Question

Consider the following data:
Date Exchange rate
January 2017 EURUSD 1.100
December 2017 EURUSD 1.144
Take the US dollar as the home currency
a. According to Purchasing Power Parity which currency area should have had the
higher rate of inflation in 2017 and by how much?

b. If inflation in the US were 3% higher than in the euro area, calculate the change
in the real value of the dollar. What are the implications of this change?

c. What are the implications of a change in the real exchange rate of a currency?

d. Explain why you would expect interest rates in the US to be higher than in the
euro area.

e. Explain why you would expect there to be no difference in the interest rates of
government bonds of any two countries in the euro area and also explain why in
practice there are differences.

Answer 1

A)
Purchasing power may be defined as quantity of a commodity that can be purchased by a unit currency.
Purchasing power parity requires that similar commodities should be identically priced in distinct markets.
In the given case above, in January 2017, EURUSD 1.100 mean 1 EUR could purchase the same amount of goods as 1.100 USD .
However in December 2017, the same goods worth 1USD could be purchased at 1.144 USD which is higher than January.

Inflation reduces the purchasing power of a currency .Given the differences in purchasing power, the home currency area (USD) should have had the higher rate of inflation by;

((1.144-1.100)/1.100)*100 =4%

b)

Value of the dollar = ((0.03*1.100) +1.100) =1.133
= 1.133
Inflation determines whether a currency will appreciate or depreciate .Currency values move in response to inflation.
Inflation reduces the purchasing power of a currency and this is reflected by the currency. .Therefore an exchange rate of 1.133 means that the USD lost 3% of its value relative to the EUR due to inflation.

C) The real exchange rate determines the price of commodities in a country relative to another country .when a common currency is used to express the prices of the commodity.
Changes in the real exchange rate affects the relative prices of commodities in two countries and the nominal exchange rate.
Changes in real exchange rate either causes appreciation or depreciation of the domestic currency. Depreciation of a domestic currency makes a country’s exports cheaper in terms of foreign currency and its imports more expensive on the other hand Appreciation of a domestic currency makes a country’s exports in terms of foreign currency expensive and its imports cheaper.

d) Interest rates are the amount in percentage charged by an investor to the borrower for the use of money .It reflects various risks and costs associated with investment and interest rates are affected by currency demands as well as Inflation.
According to fisher, nominal interest rates should be adjusted for inflation ,or stated otherwise, actual interest rate of a country is equal to the nominal interest rate minus the rate of inflation .If inflation reflects the value of a currency, interest rates should reflect both elements. Therefore a country with a higher inflation rate need have a higher interest rate to accommodate the inflation. Therefore inflation explains why the expected interest rate in the US will be higher than in the EURO area.

e) The two countries in the euro area can be said to have permanently fixed exchange rate-the euro. It is expected there is no differences in interest rate since they have a common currency, there is no longer need to exchange one currency for another it in addition reduces transaction costs of converting currencies and no uncertainties of exchange rates changes. In practice however ,there exists differences in the interests rates of the two countries due to other factors apart from exchange rate volatility .Such factors include country risk – political and economic risks, differences in inflation rates and other market imperfections.

Government debt/bond earn interest, and normally the government interest rates determine the interest rates affected by other lenders within the country. Country with higher interest rate will experience a higher rate of foreign investment in bonds, resulting in increased demand for the currency.