Question

1. Assume that the current spot rate for the Canadian dollar is 0.71 USD per C$. How will the Canadian dollar (C$) spot rate adjust over the next year according to Purchasing Power Parity (PPP), given the following information. That is, according to PPP, what is the expected appreciation/depreciation in the Canadian dollar over the next year AND what is the expected future spot rate of the Canadian dollar one year from now? Use the information in the table below to answer the aforementioned questions:

	United States	Canada
Nominal One Year Interest Rate	5%	2%
Expected One Year Inflation Rate	3%	1%
Current Spot Rate	----	0.71 USD per C$
One Year Forward Rate	----	0.73 USD per C$

Answer 1

Solution:-

If Purchasing power parity is to hold true, it would mean that the exchange rate of the two currencies will change in such a way that the price of goods one year from in the two countries will stay at the samelevels in real terms. Let's look at teh calculation below:

Current exchange rate= $0.71/C$

This means that at present if PPP holds true, than the price of a burger which ha sa price of C$1 in Canada will have a price of $0.71 in the US. Thus, adjusted for exhcnage rates the price of the burger would be the same in both countries.

Now, the expected exchange rate one year from now based on PPP is as follows:

Expected exchange rate (PPP)= $0.71*(1 + US inflation)/(1 + Canada inflation)= 0.71*(1+3%)/(1+1%)= $0.724

Thus, since the inflation rate in the US is higher, USD would depreciate against Canadian dollar to $0.724 per C$.

Appreciation in C$ during the year= (Expected exchange rate-current exchange rate)/Current exchange rate= (0.724-0.71)/0.71= 1.97%