Question

Suppose at the beginning of the year, a textbook book sells for €60 in Paris, France, and $60 in New York City, and PPP holds. Over the year, there is an inflation rate of 10 percent in France and no inflation in the United States. What exchange rate would maintain PPP at the end of the year?

Answer 1

1 USD= 1.1 Euros

Step-by-step explanation:

As per Purchasing power parity, the exchange rate between two countries is determined by the rate of inflation prevailing in the two countries.

Purchasing power parity is given by the following equation:

`(FR\ (Euro\ /USD))/(SR\ (Euro\ /USD))` =
`((1\ +\ Inf\ in\ France))/((1\ +\ Inf\ in\ USA))`

wherein, FR = 1 year forward rate of Euro per USD

SR= Spot rate of today Euro per USD

Inf= Inflation rate

Price of textbook next year in France= Euro 60 × (1 + .10)= Euro 66

Price of a textbbo in USA= $60

spot rate= 1 $= 1 euro i.e 60$ being equal to 60 euros

Forward exchange rate( Euro per dollar)= 1 ×
`((1\ +\ .10))/((1\ +\ 0))`

Forward Exchange rate will be 1 USD= 1.1 Euros