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Question 21.S-TP.1: Relative Purchasing Power Parity The inflation rate in the U...

Relative Purchasing Power Parity The inflation rate in the United States is projected at 3 percent per year for the next several years. The New Zealand inflation rate is projected to be 5 percent during that time. The exchange rate is currently NZ$ 1.66. Based on relative PPP, what is the expected exchange rate in two years?

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Based on relative PPP, the expected exchange rate in two years, E(S_{2} )  , is:

  E(S_{2} )=S_{0}\times [1+(h_{NZ} -h_{US} )]^{2}

where    h_{NZ}  is the New Zealand inflation rate. The current exchange rate is NZ$ 1.66, so the expected exchange rate is:

  E(S_{2} )=NZ\$1.66\times [1+(.05-.03)]^{2}

=NZ\$1.66\times 1.02^{2}

 =NZ\$1.73

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