Question

Suppose that exchange rate between the dollar and the peso is in equilibrium when inflation in the U.S. rises to 3.50%. At the same time, inflation in Mexico is 7.00%. If the inflation rate in the U.S. is denoted as Iʜ and the inflation rate in Mexico is I, then which of the following expressions represents the percent change in the peso under PPP?

a. 1+Iʜ/1+I -1
b. 1+I/1+Iʜ +1
c. 1+Iʜ/1+I +1
d. 1+I/1+Iʜ -1

Answer 1

The percent change in the value of the peso under PPP, when comparing U.S. inflation of 3.50% to Mexican inflation of 7.00%, is represented by the expression (1 + I) / (1 + Iᴼ) - 1, or option d. The correct option is d. 1 + I / 1 + Iᴼ - 1.

Step-by-step explanation:

When considering the impact of inflation rates on the exchange rate between two currencies under the concept of Purchasing Power Parity (PPP), if the U.S. inflation rate is Iᴼ and the Mexican inflation rate is I, the percent change in the value of the peso can be represented by the expression (1 + I) / (1 + Iᴼ) - 1.

This expression comes from the idea that if inflation is higher in Mexico than in the U.S., the value of the peso is expected to decrease relative to the dollar.

In this case, the U.S. inflation rate is 3.50% and the Mexican inflation rate is 7.00%. Plugging in these values, the percent change in the peso under PPP would be calculated as (1 + 0.07) / (1 + 0.035) - 1, which simplifies to approximately -3.382%. This suggests that, all else being equal, the value of the peso would decrease in terms of how many pesos one would need to exchange for one dollar. Therefore, the correct option is d. 1 + I / 1 + Iᴼ - 1.