Question

The U.S. inflation rate is expected to be 4 percent over the next year while the European inflation rate is expected to be 3 percent. The current spot rate of the euro is 1.03. Using purchasing power parity, the expected spot rate at the end of the year is $_____.

a) 1.04
b) 1.02
c) 1.01
d) 1.00

Answer 1

The expected spot rate of the euro, using purchasing power parity and given the U.S. inflation rate of 4 percent and the European inflation rate of 3 percent with a current spot rate of 1.03, is b) 1.02.

Step-by-step explanation:

Using purchasing power parity (PPP), we can estimate the expected spot rate of one currency relative to another by considering the inflation rates in both countries. If the U.S. inflation rate is projected to be 4 percent and the European inflation rate is projected to be 3 percent, with a current spot rate of the euro at 1.03 dollars to the euro, we would expect the euro to appreciate relative to the dollar due to the lower inflation rate in Europe.

To calculate this, we adjust the current spot rate by the difference in inflation rates. The formula for PPP is Spot Rate * (1 + home country inflation rate) = Expected Spot Rate * (1 + foreign country inflation rate). Plugging in the values, we get 1.03 * (1 + 0.04) = Expected Spot Rate * (1 + 0.03). After simplifying, the Expected Spot Rate is calculated to be approximately 1.02 dollars per euro, therefore, the correct answer is b) 1.02.