Consider the following financial data:
Inflation (expected annual) 10% 4%
1 Year Interest Rate 12% ??
Spot Exchange Rate (DM/pound) 3
Assuming the international parity conditions hold perfectly, what is the expected exchange rate in one year?
(1+ r £ ) / (1+ r DM ) = (1+ i UK ) / (1+ i GER )
or (1+0.12) / (1+ r DM ) =(1+0.10) / (1+0.04)
or 1.12 / (1+ r DM ) = 1.0576
or (1+ r DM ) = 1.12/ 1.0576 =1.0589
0r r DM = 1.0589-1= 0.0589 or 5.89%
As an approximation difference in inflation rate= difference in interest rates
difference in inflation rate = 10%-4%=6%
Therefore difference in interest rate will be 6 %. The country having higher inflation will have a higher interest rate ( ...
The solution calculates the expected exchange rate using interest rate parity conditions. The interest rates are determined using inflation rates and then the expected exchange rate is calculated.