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Question 1.3. Suppose the current EURUSD spot exchange rate is $1.1300. Eurozone inflation is 5.0%, while U.S. inflation is only 2.0%. According to purchasing power parity (PPP), which is nearest to the new EURUSD spot exchange rate that should result from the difference in inflation rates? | Financial Risk Manager Part 1 Quiz - LeetQuiz

Explanation:

Under purchasing power parity, the exchange rate should adjust in line with relative inflation:

S_1 = S_0 \times \frac{1+\pi_{US}}{1+\pi_{Eurozone}}

Because the eurozone inflation rate is higher than U.S. inflation, the euro should depreciate relative to the dollar.

S_1 = 1.1300 \times \frac{1.02}{1.05} = 1.0961

So the nearest answer is A.

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Question 1.3. Suppose the current EURUSD spot exchange rate is `$1.13`00. Eurozone inflation is 5.0%, while U.S. inflation is only 2.0%. According to purchasing power parity (PPP), which is nearest to the new EURUSD spot exchange rate that should result from the difference in inflation rates?