Question

Suppose the current exchange rate between the U.S. dollar and the Mexican peso is $0.10 = 1 peso. Furthermore, suppose the price level in the United States rises 15 percent at a time when the Mexican price level is stable. According to the purchasing power parity theory, what will be the new equilibrium exchange rate?

Answer 1

equilibrium exchange rate = $0.11 = 1 peso.

Step-by-step explanation:

The purchasing power parity theory states the future spot rate and and he current spot exchange rate between two currencies can be linked to the relative inflation rate between the two currencies. This also known as the law of one price.

The model is given as follows:

S = So× (1+Fc)/(1+Fh)

Fh- inflation rate in Mexico,-

Fc- inflation rate in US,

So - Current spot rate

S- Future spot rate

S = 0.10 × (105/100)

= $0.11

equilibrium exchange rate = $0.11 = 1 peso.