Question

Exchange rate movement

Suppose a basket of goods in Paris cost 133 euros and the same basket purchased in

New York cost $153.

A. At what exchange rate between euros and dollars is the cost of the basket of goods the same in each City?

B. Now suppose that over the next year inflation in France is expected to be 2% while in the US the forecast is for 6% inflation. What exchange rate do you expect a year from today?  

Answer 1

A. Price of basket of good in Paris =133 Euros, Price of basket of goods in New York = $153

We know that according to absolute purchasing power parity, price of basket goods should be same in two different countries after taking in consideration the exchange rate.

Spot rate(Euro/$) = Price of basket of goods in Paris / Price of basket of goods in New York = 133 / 153 = 0.8692 Euro / $

Thus Exchange rate between Euro and dollar = 0.8692 Euro / $

B. Expected inflation in France = 2% and Expected inflation in USA = 6%

Now using relative purchasing power parity,

Percentage change in Euro / $ = Expected inflation in France - Expected inflation in USA = 2% - 6% = - 4%

Hence Dollar should depreciate by 4% relative to Euro over next one year

So we get

Percentage change in Euro / $ over a year = (Expected exchange rate in a year / Current exchange rate) - 1 = -4%

Now , (Expected exchange rate in a year / Current exchange rate) - 1 = -4%

(Expected exchange rate in a year / 0.8692) - 1 = -4%

Expected exchange rate in a year / 0.8692 = 1 - 4% = 96%

Expected exchange rate in year = 96% x 0.8692 = 0.8344 Euro / $

Hence Exchange rate expected in one year = 0.8344 Euro / $