Question

2. The current price level in the U.S. is $14,000 per consumption bundle, and £10,000 per consumption bundle in the U.K.. The spot rate is $1.65/£. The annual inflation rate is expected to be 2% in the U.S. and 5% in the U.K.

(1) Assume £ weakens against dollar by 4% in the next year. Discuss with calculations (a) the impact on GBP’s purchasing power in U.S. in the next year; (b) the impact on GBP’s purchasing power in U.K. in the next year; (c) which country will become more competitive in the world market next year

(2)    Calculate to conclude the deprecation/appreciation of GBP that leads to no change to the trade between two countries in the next year.

Answer 1

Here,

AS Per Purchasing power Parity.

Cost of Consumption Bundle = $14,000 = Pound 10000

Spot Rate = $1.65/ pound,

Inflation in US = 2%, so Cost of Consumption Bundle Next Year = 1.02*14000 = $14,280

Inflation in UK = 5%, so cost of consumption Bundle Next Year = 1.05*Pound 10000 = Pound 10500

1) When Pound Weakens against $ by 4%, new exhange rate is x say

So we have,

(x-1.65)/1.65 = -.04

Therefore, x = 1.584

a) The GBP's purchasing power in the US decreases due to lower spot rate as shown above

b ) GBP's pruchasing power in the UK Decreases to pound 10500 as shown in the calculation above  

c) If we consider all transaction in $,

Than cost of bundle in US = $14,280

Cost of Bundle in UK = Pound 10,500

Exhange rate = 1.584$/ Pound,

So 10,500 Pounds = $10,500*1.584 = $16,632

So US is more competitive

2) For The countries to be at same levels i.e. no change to the trade between two countries in the next year

We have, $14,280 = Pound 10,500 ( Same Purchasing Power)

So, 1 Pound = 14280/10500 = 1.36 $/ Pound

So inorder for the trade to be same, Pound Must depreciate by,

(1.36 - 1.65)/1.65 = 17.57%