Question

(20.4) The exchange rate between the United States of Albion (U.S.A.) and the Republic of Oz is now 1:1 with inflation in both countries expected to be 2% and interest rates 4%.

What does PPP imply about the exchange rate in 20 years time?

If inflation in the U.S.A. increases to 3% how does your answer change?

What happens to the current exchange rate if U.S.A. interest rates rise to 5% along with inflation increasing to 3%?

Answer 1

What does PPP imply about the exchange rate in 20 years time?

• Since both countries have similar variables, hence PPP is also similar between these two countries.

If inflation in the U.S.A. increases to 3% how does your answer change?

• Increase in inflation reduces the export competitiveness. Thus, fall in export would hurt the value of dollar. Now value of dollar would be depreciated. Exchange rate would be against USA and purchasing power of dollar would get reduced. Now one dollar would be able buy lesser commodity in Republic of Oz.

What happens to the current exchange rate if U.S.A. interest rates rise to 5% along with inflation increasing to 3%?

• High interest rate invites investment and hot money enters the country. Thus, it leads to the appreciation of domestic currency as the demand for domestic currency rises. Hence, it will help to nullify the adverse impact of rise in inflation. One point rise in inflation is likely to get nullified by the one percent rise in the interest rate. Therefore, economies reach the previous equilibrium.