Question

In: Finance

Assuming inflation rates in the U.S. and Switzerland are 5% and 3% respectively. Spot exchange rate...

Assuming inflation rates in the U.S. and Switzerland are 5% and 3% respectively. Spot exchange rate of Swiss francs is US$1.05. Purchasing Power Parity (PPP) and international Fisher effect (IFE) are held in this case.

Required:

(a) Calculate the expected percentage change of spot exchange rate of Swiss francs.
(b) Calculate the U.S. interest rate if interest rate in Switzerland is 3.5%.
(c) “If PPP is held, IFE is held too.” Explain whether this statement is correct.

Expert Solution

According to the PPP model the exchange rate is calculated by solving the following equation:

As the inflation rate is higher for Switzerland, the Swiss franc will depreciate by 2%

So new spot rate is 1.07 swiss franc per USD

If IFE is held then the real interest remains constant everywhere. If US interest rate is 3.5% then we can calculate the real interest rate using the following equation:

, here r is the real interest rate

Now we substitute the value of r to find out the interest rate for Switzerland:

It is not always necessary that the IFE is held if PPP is hel because IFE requires all three conditions to be met which are, PPP to hold, real interest rate being same and the expected inflation to occur. If any one is not true then IFE will not hold so the given statement is wrong.

jeff jeffy answered 6 months ago

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