Assume the spot market exchange rate for $1 is currently A$1.1904. The expected inflation rate is 3.3 percent in Australia compared to the U. S. rate of 2.8 percent. What is the expected exchange rate one year from now if relative purchasing power parity exists?

a. $1.1844

b. $1.2062

c. $1.1964

d. $1.2286

Expected exchange rate $1 = A$1.1962

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)

Fc - inflation rate in Australia - 3.3

Fh - Inflation rate in the US - 2.8

S - Future spot rate-?

So - Current spot rate - A$1.1904

Expected exchange rate one year from now

= 1.1904 * (1.033) / (1.028)

= 1.19618

= A$1.1962

Answer: c. $1.1964

Explanation:

The Expected Rate is calculated as follows,

Expected Rate = ((1 + Australia inflation rate) / (1 + U. S inflation rate)) * spot rate

Plugging in the figures therefore we will have,

Expected Rate = ((1+0.033) / (1 + 0.028)) * 1.1904

Expected Rate = $1.1964

$1.1964 is the expected exchange rate one year from now if relative purchasing power parity exists.