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Question 21.4:  It’s All Relative  Suppose the Japanese exchange rate is c...

It’s All Relative 

Suppose the Japanese exchange rate is currently 105 yen per dollar. The infl ation rate in Japan over the next three years will run, say, 2 percent per year, whereas the U.S. inflation rate will be 6 percent. Based on relative PPP, what will the exchange rate be in three years?

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Because the U.S. inflation rate is higher, we expect that a dollar will become less valuable. The exchange rate change will be 2% – 6% = -4% per year. Over three years, the exchange rate will fall to:

E(S_{3} )=S_{0}\times [ 1+( h_{FC}-h_{US})]^{3}=105\times [1+(-.04)]^{3}  =92.90

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