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ACCA Applied Skills · Financial Management · Causes of exchange rate differences and interest rate fluctuations

The spot rate between the dollar ($) and the euro (€) is $1.2000 per €1. Annual inflation is expected to be 5% in the US and 2% in the eurozone. Using purchasing power parity, what is the expected spot rate in one year, in $ per €1 (to four decimal places)?

The expected spot rate is $1.2353 per euro. Under purchasing power parity, the currency with higher inflation depreciates, so the dollar cost of a euro rises by 1.05 divided by 1.02, taking 1.2000 to 1.2353.

  1. A1.2353Correct
  2. B1.1655
  3. C1.2000
  4. D1.2706

Explanation

PPP: future spot = spot x (1 + inflation of $ country) / (1 + inflation of € country) = 1.2000 x 1.05/1.02 = 1.2000 x 1.029412 = 1.2353. The $ is expected to weaken because US inflation is higher. Option 1.1655 inverts the ratio, giving 1.2000 x 1.02/1.05.

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