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IAI Actuarial Core Principles · Business Economics · Balance of payments and exchange rates

According to relative purchasing power parity, if India's expected annual inflation is 6% and US expected annual inflation is 2%, the rupee per dollar spot rate would be expected to:

The rupee per dollar rate is expected to rise by about 4% a year. Relative purchasing power parity says the currency of the higher-inflation country depreciates by about the inflation differential, which is 6% minus 2%, so the rupee weakens against the dollar.

  1. AFall by about 4% a year, as the rupee appreciates
  2. BRemain unchanged because inflation affects only domestic prices
  3. CRise by about 4% a year, as the rupee depreciatesCorrect
  4. DRise by about 8% a year, as the rupee depreciates
  5. Fall by about 8% a year, as the rupee appreciates

Explanation

Relative PPP says the currency of the higher-inflation country depreciates by roughly the inflation differential. The differential is 6% minus 2%, which is 4%. The rupee price of a dollar therefore rises by about 4% a year. Adding the inflation rates gives 8%, which is the wrong calculation.

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