Question

The inflation rate is 3% in Colombia and 8% in Britain. The spot ER between British pound and COP is BP .6/euro1. What is the expected spot exchange rate among the 2 currencies? Compute the results according to both currencies being in the denominator. Explain PPP ( explain how it holds true by discussing both the goods/services and capital markets.) SHOW WORK and answer both questions please

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Answer #1

According to PPP,

Expected Spot Exchange rate = Spot Rate x [(1 + inflationp) / (1 + inflationB)]

In terms of Euro,

Expected Spot Exchange rate = 0.6 x [1.03/1.08] = BP 0.5722 / 1 euro

In terms of BP,

Expected Spot Exchange rate = [1/0.6] x [1.08/1.03] = Euro 1.7476 / 1 BP

Purchasing power parity theory states that, in the long run, the price paid for a product in two countries using different currencies will be same after the exchange rate differences have been accounted for. This itself is based on the law of one price i.e. price of a given commodity is same no mater what currency is used to purchase it.

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