Question

Two countries, Great Britain and the United States, produce just one good: beef. Suppose the price of beef in the United States is $2.80 per pound and in Britain it is £3.70 per pound.

(a) According to PPP theory, what should the $/£ spot exchange rate be?

(b) Suppose the price of beef is expected to rise to $3.10 in the U.S., and to £4.65 in Britain. What should the one-year forward $/£ exchange rate be?

(c) Given your answers to parts (a) and (b), and given that the current interest rate in the United States is 10 percent, what would you expect the current interest rate to be in Britain?

Answer 1

Step 1

a) The exchange rate is $2.80=3.70 pounds. Divide both sides by 2.8

$1= 1.32 pounds

STEP 2

b) The exchange rate is $3.10=4.65 pounds. Divide both sides by 3.1

$1=1.5 pounds

STEP 3

(S₁-S₂/S₂) * 100 = i(s) - i(w)

S1 is the original exchange rate or 1.32 pounds per dollar. S2 is the end exchange rate or 1.5. i$ is listed as 10%, solve for iW.

[(1.32-1.5)/1.5] * 100 = 10 - i(w)

22%