An American (USA) car currently costs $18,000 while the equivalent United Kingdom (UK) car costs £10,000. The nominal UK interest rate is 8 per cent and the nominal US interest rate is 5 per cent. The interest rate in the two countries is equal at 2 per cent and the nominal interest rate differential is full explained by expected inflation differentials. (i) Determine the current Purchasing Power Parity (PPP) exchange rate measured as dollars per pound. (ii) Assuming that international investors are risk neutral, calculate the percentage by which the pound is expected to appreciate or depreciate against the dollar. (ii) If the actual inflation rate coincides with the expected inflation rate and absolute purchasing power p holds on a continuous basis, calculate the PPP exchange rate measured as dollars per pound in one time.

ENGR.ECONOMIC ANALYSIS
14th Edition
ISBN:9780190931919
Author:NEWNAN
Publisher:NEWNAN
Chapter1: Making Economics Decisions
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An American (USA) car currently costs $18,000 while the equivalent United Kingdom (UK) car costs
£10,000. The nominal UK interest rate is 8 per cent and the nominal US interest rate is 5 per cent. The real
interest rate in the two countries is equal at 2 per cent and the nominal interest rate differential is fully
explained by expected inflation differentials.
(i)
Determine the current Purchasing Power Parity (PPP) exchange rate measured as dollars per pound.
(ii)
Assuming that international investors are risk neutral, calculate the percentage by which the pound is
expected to appreciate or depreciate against the dollar.
(ii)
If the actual inflation rate coincides with the expected inflation rate and absolute purchasing power parity
holds on a continuous basis, calculate the PPP exchange rate measured as dollars per pound in one year's
time.
Transcribed Image Text:An American (USA) car currently costs $18,000 while the equivalent United Kingdom (UK) car costs £10,000. The nominal UK interest rate is 8 per cent and the nominal US interest rate is 5 per cent. The real interest rate in the two countries is equal at 2 per cent and the nominal interest rate differential is fully explained by expected inflation differentials. (i) Determine the current Purchasing Power Parity (PPP) exchange rate measured as dollars per pound. (ii) Assuming that international investors are risk neutral, calculate the percentage by which the pound is expected to appreciate or depreciate against the dollar. (ii) If the actual inflation rate coincides with the expected inflation rate and absolute purchasing power parity holds on a continuous basis, calculate the PPP exchange rate measured as dollars per pound in one year's time.
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