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Answer: $1.0961
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**.
Author: Manit Arora
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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?
A
$1.0961
B
$1.1128
C
$1.1300
D
$1.1403
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