Parity: Inflation and Exchange Rate
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
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