Question

2. You are given the following information. The current dollar-pound exchange rate is $2 per pound. A U.S. basket that costs S100 would cost $120 in the United Kingdom. For the next year, the Fed is predicted to keep U.S. inflation at 2% and the Bank of England is predicted to keep UK. inflation at 3%. The speed of convergence to absolute PPP is 15% per year. A. What is the expected U.S. minus U.K. inflation differential for the coming year? B. What is the current U.S. real exchange rate, qu K/us, with the United Kingdom? C. How much is the dollar overvalued/undervalued? D. What do you predict the U.S. real exchange rate with the United Kingdom will be in one year's time? E. What is the expected rate of real depreciation for the United States (versus the United Kingdom)? F. What is the expected rate of nominal depreciation for the United States (versus the United Kingdom)? G. What do you predict will be the dollar price of one pound a year from now?

Answer 1

e. What is the expected rate of real depreciation for the United States (versus the United Kingdom)?

Answer: Because the real exchange rate will reduce by 0.03, thus rate of real depreciation is equal to -2.5% (= -0.03/1.20). It indicates a real appreciation in the United States relative to the United Kingdom

　

f. What is the expected rate of nominal depreciation for the United States (versus the United Kingdom)?

Answer: The expected rate of nominal depreciation can be computed as:

Inflation differential + expected real depreciation

Here, inflation differential is -1% and the expected real appreciation is -2.5%

Thus the expected nominal depreciation is -3.5%.

It indicates an expectation of a 3.5% appreciation in the U.S. dollar relative to the British pound

　

g. What do you predict will be the dollar price of one pound a year from now?

Answer: The current nominal exchange rate is $2 per pound and an expectation of a 3.5% appreciation in the dollar , thus the expected exchange rate in one year equals $1.93 (= $2 * (1- 0.035).