Question

1. Interest Rate Parity, Purchasing Power Parity, International Fisher deEffect Separated by more than 3,000 nautical miles and five time zones, money and foreign exchange markets in both London and New York are very efficient. The following information has been collected from the respective areas: Assumptions London New York Spot exchange rate ($/pound) 1.3264 1.3264 One-year Treasury bill rate 1.5% 2.5% Expected inflation rate Unknown 2.0% a. Estimate today's one-year forward exchange rate F between the dollar and the pound using Covered Interest Rate Parity. b. Find approximate expected inflation in London next year. Is it smaller or larger than New York expected inflation? Why? You can do the forecast using PPP or International Fisher Effect. If you use PPP then assume that the Expected exchange rate E(S) is the same as the forward exchange rate F that you found in (a). Then solve for expected inflation in London using PPP formula. If you use International Fisher effect assume that the real interest rates for two countries are the same.

Answer 1

a.) If S is the spot rate and F the forward rate, and r_f and r_d are foreign currency interst rates and domestic currency interest rates respectively, then using Covered Interest Rate Parity relation:

     = 1.3264 x (1 + 0.025) / (1+0.015)

     = 1.3395 ($/pound)

b.) According to Fisher effect, the real interest rates should be same in London and in US,

Now, Nominal Rate =(1+Real Rate) x (1+Inflation)-1

=> 1+Real Rate = (1+Nominal Rate)/(1+Inflation)

In the table given in Ques, taking the values of US in terms of percentage,

1+Real Rate_US= (100+2.50)/(100+2)

1+Real Rate_US= 102.50/102

1+Real Rate_US= 1.004901

Real Rate_US= 0.4901%

Using Fisher's concept,

Real Rate_UK= Real Rate_US =0.4901%

=> 1+Inflation = (1+Nominal Rate)/(1+Real Rate_UK)

                       = (100 + 1.5)/(100+0.4901)

                       = 1.016451

=>Expected Inflation in London Next Year = 1.01%

The expected inflation in London is expected to be higher than inflation in New York.