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Assume $1 is currently equal to £.7658. Also assume the expected inflation rate in the U.K. is 3.6 percent while it is 3.3 percent in the U.S. What is the expected exchange rate four years from now if relative purchasing power parity exists?

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Answer:

$1 to £.7750

Explanation:

If relative purchasing power parity exists, the new exchange rate must account for the difference in inflation in order to keep the parity between the actual values of both currencies as follows:

[tex]\$1=\pounds 0.7658\\\$1*(1.033)^4=\pounds 0.7658*(1.036)^4\\\$1=\pounds0.7750[/tex]

The new exchange rate, in 4 years, is expected to be $1 to £.7750.

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