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Hi,
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.
According to the four-way equivalence model, which of the following statements is/are true?
(1) Country X’s nominal interest rate should be 7·06% per year
(2) The future (expected) spot rate after one year should be 1·4571 dinar per $1
(3) Country X’s real interest rate should be higher than that of country YA. 1 only
B. 1 and 2 only
C. 2 and 3 only
D. 1, 2 and 3ANSWER IS B.
(1)
I calculated the different way (not the same way as answer) but still got the answer of 7.06% but I don’t understand the logic behind my workingMy working:
1.4571 (F0) = 1.5000 dinar x (1.04 / 1+i)
i = 7.06%
Can you explain?
Your answer ‘works’ because you were assuming that the expected spot rate is 1.4571 from statement 2. This happened to be correct here, but it might not have been correct.
In theory interest rates go up and down in line with inflation rates.
So (1+ i) / 1.04 = 1.05 / 1.02
Solving this gives i = 0.070588 (or 7.06%).
So statement 1 is true.For statement 2 we use the PPP formula, and so the expected spot rate is 1.5000 x (1.02/1.05) = 1.4571.
(Using the IRP formula and interest rates of 4% and 7.0588% will give the same result, because again (in theory) inflation rates and interest rates move up and down together.)
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