Question

Theresa Nunn is planning a​ 30-day vacation on Pulau​ Penang, Malaysia, one year from now. The present charge for a luxury suite plus meals in Malaysian ringgit​ (RM) is RM1,043​/day. The Malaysian ringgit presently trades at RM3.1350​/$. She determines that the dollar cost today for a​ 30-day stay would be $9,980.86. The hotel informs her that any increase in its room charges will be limited to any increase in the Malaysian cost of living. Malaysian inflation is expected to be 2.7191​% ​annum, while U.S. inflation is expected to be 1.252​%.

a. How many dollars might Theresa expect to need one year hence to pay for her​ 30-day vacation?

b. By what percent will the dollar cost have gone​ up? Why?

Answer 1

a]

According to Relative Purchasing Power Parity (RPPP), the country with the higher inflation rate would see its currency depreciate by the inflation differential.

As Malaysian inflation is higher, its currency would depreciate by the inflation difference, which is 2.7191% - 1.252% ==> 1.4671%

Expected exchange rate after one year ($/RM) = (1 / 3.1350) * (1 - 1.4671%) ==> 0.3143

Expected exchange rate after one year (RM/$) = 1 / 0.3143 ==> 3.1817

Expected cost of vacation after one year (in RM) = current cost + Malaysian inflation

Expected cost of vacation after one year (in RM) = (30 * 1,043​) + 2.7191% ==> RM 32,140.8064

Expected cost of vacation after one year (in $) = Cost in RM / expected exchange rate after one year

Expected cost of vacation after one year (in $) = 32,140.8064 / 3.1817 ==> $10101.77

b]

% increase in dollar cost = ($10101.77 - $9,980.86) / $9,980.86 ==>  0.01211419, or 1.21%

Adjusting for rounding, this is equal to the US inflation

The purchasing power parity theory says that goods will cost the same in every country, adjusted for shipping and transaction costs. Hence, the increase in dollar cost is equal to the US inflation rate