# Parity: Inflation and Exchange Rate

Pages: 2 (484 words) Published: August 5, 2013
Assignment # 2 – Parity Relationships
Due midnight, Wednesday, 7/17
By Class Time on Thursday, 7/18

1.

| London| New York|
Spot Exchange Rate (\$/GBP)| 1.3264| 1.3264|
Interest Rates| 3.900%| 4.500%|
Expected Inflation Rates| 0.650%| 1.250%|

a. What is the expected rate of inflation in London?
iPC - iBC = PC - BC
4.500% - 3.900% =1.250% - BC
PC = 0.650%
b. Using Uncovered Interest Rate Parity, what is the value of the expected spot exchange rate in two years? E(ST) = S0 * [(1+i)/(1+i*)]T
E(S2) = 1.3264 * [(1.045)/(1.039)]2
E(S2) = \$1.3418/GBP
c. Using Relative Purchasing Power Parity, what is the value of the expected spot exchange rate in one year? E(ST) = S0 * [(1+)/(1+*)]T
E(S1) = 1.3264 * (1.1025/1.0065)1
E(S1) = \$1.3343/GBP

d. Assume that inflation in London is 1.250%, the same as in New York. Determine the real rate of interest in London and in New York. i = r + E()
London| | New York|
3.900% = r + 1.250%| | 4.500% = r + 1.250%|
2.650% = r| | 3.250% = r|

e. Referring to the prior question, what is the likely impact on capital flows moving between London and New York? Since the interest rate is 3.250% in New York and 2.650% in London, the dollar is expected to depreciate against the British pound by about 0.6% [3.250%-2.650%] per year. Upon depreciation of the US dollar, London consumers will begin to purchase more US goods, and we will begin to purchase less British goods. London will experience a trade deficit and we will experience a trade surplus.

2. During the past year, the consumer price indexes of the U.S. and Europe rose by 2% and 5%, respectively. During this same period the exchange rate (\$/euro) didn’t change from its value of \$1.20/euro. f. According to purchasing power parity, by what percentage should the value of the euro have changed over this same period? e \$ - €

e 2% - 5%
e -3%
The € should have depreciated against the \$ by...