Explanation:
With PPP, the currency of the country with the higher inflation rate tends to depreciate. Since U.S. inflation (4.0%) exceeds Eurozone inflation (2.0%) by 2.0%, the USD depreciates and the EUR appreciates by about 2.0%.
Starting from EUR/USD $1.40:
$1.40 \times 1.02 = $1.4280
So the euro appreciates to EUR/USD $1.4280, which corresponds to C.
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Question 1.2. The current spot exchange rate between the Euro and the U.S. dollar is EUR/USD $1.40 (base/quote). Relative inflation rates shift from parity such that the inflation rate in the Eurozone is 2.0%, but the inflation rate in the United States is 4.0%. According to purchasing power parity (PPP), what should be the impact on the exchange rate?
A
The Euro will depreciate by $0.0510 to EUR/USD $1.4510
B
The Euro will depreciate by $0.0510 to EUR/USD $1.3490
C
The Euro will appreciate by $0.0280 to EUR/USD $1.4280
D
The Euro will appreciate by $0.0280 to EUR/USD $1.3720