Explanation:
B is TRUE: Depreciation in the base currency (EUR) to about ¥127.15.
Purchasing power parity (PPP) is a variation on the Law of One Price (that is especially manifest in our Fixed Income topics). PPP asserts that, conditional on neither trade barriers nor transaction, there should not be a sustainable arbitrage due solely to mispriced exchange rates. Put another way, a single amount (e.g., whether in dollars or euros) ought to purchase approximately the same basket of goods. This reduces to the following approximation: inflation rate differential ≡ %Δ spot FX rate.
Specifically:
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The spot exchange rate for EURJPY (aka, Yuppy) is ¥133.00 where the Japanese Yen is the quote currency. Over the next period, the expected inflation rates in the eurozone and Japan, respectively, are +5.50% and +1.10%. According to purchasing power parity, which of the following is TRUE?
A
a) Appreciation in the euro (EUR) to about ¥143.06 EURJPY
B
b) Depreciation in the euro (EUR) to about ¥127.15 EURJPY
C
c) Depreciation in the Yen (JPY) to about €0.0067 JPY/EUR
D
d) Incomplete information because we need their respective risk-free rates
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