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Country X uses the dollar as its currency and country Y uses the dinar.
Country X’s expected inflation rate is 5% per year, compared to 2% per year in country Y. Country Y’s nominal interest rate is 4% per year and the current spot exchange rate between the two countries is 1·5000 dinar per $1.
The nominal interest is 7.06%. It has been calculated like this; 1.04*1.05/1.02.
I do not understand the logic behind the calculation. Can you pls explain whats happening there?In theory, interest rates and inflation rates in two different countries will move up and down together.
So the calculation is using the purchasing power parity formula provided in the exam, but applying it to the interest rate instead of to the exchange rate.
I get the concepts but I am having trouble understanding the mathematical steps in the calculation.Why are we dividing the two inflation rates and then multiplying it by country y’s interest rate to arrive at country x’s interest rate ?
If you were using the PPP formula to forecast the future exchange rate you would divided the two inflation rates and multiply by the exchange rate, as I explain in my free lectures. Here we are doing exactly the same thing but applying it to the interest rate instead of to the exchange rate.
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