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inflation in Australia is anticipated to be 1.6% p.a. and in the United States the current...

inflation in Australia is anticipated to be 1.6% p.a. and in the United States the current estimate is 2.1% p.a. The AUD/USD spot rate is currently at 0.6302

Using this information, what is the expected value in equilibrium of the US dollar in 3 years' time? (Accurate to 4 decimal places). Clearly state which equilibrium relationship you used to calculate this – and show all workings.

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Answer #1

Purchasing Power Parity (PPP): In the state of equilibrium, the future spot rate of a foreign currency will differ from the existing spot rate by an amount that equals (in %) the inflation differential between the home and foreign country

Inflation Differential between USD and AUD is 2.1% - 1,6% = 0.5%. Thus USD will depreciate every year by 0.5%. i.e. 1 USD will be be able to buy 5% less AUD after 1 year. Thus

AUD / USD after 3 year = 0.6302 * 95%* 95%* 95% = 0.5402

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