The annual inflation rate in the US is expected to be 6 whil

The annual inflation rate in the US is expected to be 6%, while it is expected to be 2.5% in Australia. The current spot rate(on 10/07/18) for the Australian Dollar (AD) is $0.85.

Required

i) According to Purchasing Power Parity, estimate the expected percenatage change in the value of the AD during a one-year period and calculate its AD expected values at 10/07/19.

ii) Suppose the value of the AD turned out to be $0.865 on 10/07/18, what is the real exchange? Which currency has experienced gain(how much) and which a loss (how much), in real purchasing power during the period?

iii) If the real rate of interest is expected to be 3% both in the US and Australia, use the Fisher model to calculate the nominal rates of interest in USA and in Australia.

Solution

i)The Expected value of Australian Dollar = Spot rate * ( 1 + Inflation of variable currency)/ (1+ inflation of fixed currency) = 0.85 * ( 1 + 2.5%)/(1+6%) = 0.82193

Percentage Change in value of AD = ( 1 + Inflation of variable currency)/ (1+ inflation of fixed currency) - 1 = -0.03302 or -3.30%

ii) Real Rate of AD = 0.865 * ( 1 + Inflation of fixed currency)/ (1+ inflation of variable currency) = 0.865 * (1 + 6%0/(1+ 2.5%) = 0.89454

iii) (1+ Nominal Rate ) = ( 1+ Real rate ) * ( 1+ inflation ) -1
Nominal rate of USA =  ( 1+ Real rate ) * ( 1+ inflation ) -1 = ( 1+ 3%) * ( 1+6%) -1 = 9.18%
?Nominal rate of Australia =  ( 1+ Real rate ) * ( 1+ inflation ) -1 = ( 1+ 3%) * ( 1+2.5%) -1 = 5.575%

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