(a) If a bottle of champagne costs €20 and the same bottle cost $30, what spot rate ($/€) establishes the Law of One Price (purchasing power parity) for these two commodities?
(b) If U.S. and euro expected inflation rates are 3% and 2% respectively, (a) what is the expected percentage change in the dollar rate? (b) what is the one-year forecast for the PPP rate, if the spot rate is the same as in part (a)?
Spot Rate = Cost of Chamagne on US / Cost of Chamagne on Europe
= 30 / 20
1 Euro = $ 1.50
Forward Rate =
Expected % change = 1% (approximately)
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