10. Interpreting Inflationary Expectations.

If investors in the United States and Canada require the

same real interest rate, and the nominal rate of interest is 2 percent higher in Canada, what does this
imply about expectations of U.S. inflation and Canadian inflation? What do these inflationary
expectations suggest about future exchange rates?

ANSWER: Expected inflation in Canada is 2 percent above expected inflation in the U.S. If these
inflationary expectations come true, PPP would suggest that the value of the Canadian dollar should
depreciate by 2 percent against the U.S. dollar.
14. IFE. Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United
States is 8 percent for one-year securities that are free from default risk. What does the IFE suggest
about the differential in expected inflation in these two countries? Using this information and the
PPP theory, describe the expected nominal return to U.S. investors who invest in Mexico.

ANSWER: If investors from the U.S. and Mexico required the same real (inflation-adjusted) return,
then any difference in nominal interest rates is due to differences in expected inflation. Thus, the
inflation rate in Mexico is expected to be about 40 percent above the U.S. inflation rate.

According to PPP, the Mexican peso should depreciate by the amount of the differential between U.S.
and Mexican inflation rates. Using a 40 percent differential, the Mexican peso should depreciate by
about 40 percent. Given a 48 percent nominal interest rate in Mexico and expected depreciation of
the peso of 40 percent, U.S. investors will earn about 8 percent. (This answer used the inexact
formula, since the concept is stressed here more than precision.)
18. Estimating Depreciation Due to PPP. Assume that the spot exchange rate of the British pound is
$1.73. How will this spot rate adjust according to PPP if the United Kingdom experiences an
inflation rate of 7 percent while the United States experiences an inflation rate of 2 percent?

ANSWER: According to PPP, the exchange rate of the pound will depreciate by 4.7 percent.
Therefore, the spot rate would adjust to $1.73 × [1 + (–.0467)] = $1.649.
19. Forecasting the Future Spot Rate Based on IFE. Assume that the spot exchange rate of the
Singapore dollar is $.70. The one-year interest rate is 11 percent in the United States and 7 percent in
Singapore. What will the spot rate be in one year according to the IFE? What is the force that causes
the spot rate to change according to the IFE?

ANSWER: $.70 × (1 + .0374) = $.7262.

The force that causes this expected effect on the spot rate is the inflation differential. The anticipated
inflation differential can be derived from interest rate differential.
21. Inflation and Interest Rate Effects. The opening of Russia's market has resulted in a highly volatile
Russian currency (the ruble). Russia's inflation has commonly exceeded 20 percent per month.
Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual
inflation rate in Russia.

a. Explain why the high Russian inflation has put severe pressure on the value of the Russian ruble.

ANSWER: As Russian prices were increasing, the purchasing power of Russian consumers was
declining. This would encourage them to purchase goods in the U.S. and elsewhere, which
results in a large supply of rubles for sale. Given the high Russian inflation, foreign demand for
rubles to purchase Russian goods would be low. Thus, the ruble’s value should depreciate
against the dollar, and against other currencies.

b. Does the effect of Russian inflation on the decline in the ruble’s value support the PPP theory?
How might the relationship be distorted by political conditions in Russia?
 ANSWER: The general relationship suggested by PPP is supported, but the ruble’s value will not
normally move exactly as specified by PPP. The political conditions that could restrict trade or
currency convertibility can prevent Russian consumers from shifting to foreign goods. Thus, the
ruble may not decline by the full degree to offset the inflation differential between Russia and the
U.S. Furthermore, the government may not allow the ruble to float freely to its proper
equilibrium level.

c. Does it appear that the prices of Russian goods will be equal to the prices of U.S. goods from the
perspective of Russian consumers (after considering exchange rates)? Explain.

ANSWER: Russian prices might be higher than U.S. prices, even after considering exchange
rates, because the ruble might not depreciate enough to fully offset the Russian inflation. The
exchange rate cannot fully adjust if there are barriers on trade or currency convertibility.

d. Will the effects of the high Russian inflation and the decline in the ruble offset each other for
U.S. importers? That is, how will U.S. importers of Russian goods be affected by the conditions?

ANSWER: U.S. importers will likely experience higher prices, because the Russian inflation may
not be completely offset by the decline in the ruble’s value. This may cause a reduction in the U.S.
demand for Russian goods.
24. IFE. Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-year
interest rates in Europe are 5 percent, while one-year interest rates in the U.S. are 3 percent. Beth
converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back
to dollars. The current spot rate of the euro is $1.10.

a. According to the IFE, what should the spot rate of the euro in one year be?
b. If the spot rate of the euro in one year is $1.00, what is Beth’s percentage return from her
strategy?
c. If the spot rate of the euro in one year is $1.08, what is Beth’s percentage return from her
strategy?
d. What must the spot rate of the euro be in one year for Beth’s strategy to be successful?

ANSWER:

a.
(1+i h )
ef = −1
(1+i f )
(1 . 03)
¿ −1=−1 . 90 %
(1 . 05)

If the IFE holds, the euro should depreciate by 1.90 percent in one year. This translates to a spot rate
of $1.10 × (1 – 1.90%) = $1.079.

b.

1. Convert dollars to euros: $100,000/$1.10 = €90,909.09

2. Invest euros for one year and receive €90,909.09 × 1.05 = €95,454.55
3. Convert euros back to dollars and receive €95,454.55 × $1.00 = $95,454.55
 The percentage return is $95,454.55/$100,000 – 1 = –4.55%.

c.

1. Convert dollars to euros: $100,000/$1.10 = €90,909.09

2. Invest euros for one year and receive €90,909.09 × 1.05 = €95,454.55
3. Convert euros back to dollars and receive €95,454.55 × $1.08 = $103,090.91

The percentage return is $103,090.91/$100,000 – 1 = 3.09%.

d. Beth’s strategy would be successful if the spot rate of the euro in one year is greater than $1.079.
35. Implications of PPP. Today’s spot rate of the Mexican peso is $.10. Assume that purchasing
power parity holds. The U.S. inflation rate over this year is expected to be 7%, while the Mexican
inflation over this year is expected to be 3%. Wake Forest Co. plans to import from Mexico and will
need 20 million Mexican pesos in one year. Determine the expected amount of dollars to be paid by
the Wake Forest Co. for the pesos in one year.

ANSWER
[(1.07)/(1.03)] -1 = 3.8835%. So the expected future spot rate is $.1038835. Wake Forest Co. will
need to pay $.1038835 x 20 million pesos = $2,077,710.