Question

1. Assume the spot rate of the euro is $1.16, and over the next year the Eurozone inflation rate is 2% while the US inflation rate is 3%. According to purchasing power parity (PPP), what will the spot exchange rate be after one year? Assume the spot rate of the euro is $1.16 and the one-year interest rate for the Eurozone and the US are both initially 4.5%. Then assume that the US interest rate decreases to 4% while the Eurozone interest rate remains at 4.5%. According to the international Fisher effect (IFE),
2. 1. What will the spot exchange rate be after one year?
3. 2. What is the underlying factor that would cause such a change in the interest rate differential?

Answer 1

a. Please see the below image

b. Underlying factor that would cause change in the interest rate differential is as follows:

International Fisher affect talks about the inflation in a country.

Fishers equation for the inflation is P=V*M/Q("P" represents Prices or inflation, "V" represents Velocity at which money is flowing in the economy, "M" represents Money supply in the economy, "Q' represents Quantity of goods and services can be bought)

So, if inflation in a country is increasing it represents that there is increase in Velocity of money circulation and increase in the money supply in the economy.

Example for increase in Velocity: In 2017 the average debtors collection period of X Inc. is 30 days. But in the year 2018 the average debtors collection period is reduced to 20 days. It means X inc. is able to collect its due amounts 10 days earlier than previous which increase the present purchasing power.

Example for increase in Money supply: Suppose in a country banks were offering the Loans at the lower interest rates, then more people in the country will apply for loan and it leads to increase in the money supply in the economy which increase the peoples present purchasing power and in turn leading to increase in present purchasing power.

In the question it is mentioned that US inflation rate is reduced from 4.5% to 4% which means the money circulation and velocity if money in the US got reduced when compared to previous year.

Exchange rates after one year will be as follows.