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Hi sir,
Q: Which of the following statements support the finance director’s belief that the euro will depreciate against the dollar?
(1) The dollar inflation rate is greater than the euro inflation rate
(2) The dollar nominal interest rate is less than the euro nominal interest rate
Why is statement (2) correct but statement (1) is incorrect? If the dollar inflation rate is greater than euro inflation rate, doesn’t that means that euro will depreciate against dollar?
If you look at the purchasing power parity formula on the formula sheet, then you will see that if the dollar inflation is the higher then the $/€ exchange rate will be higher. This means that 1€ will buy more $’s i.e. the dollar will have depreciated (the euro will have appreciated).
As far as interest rates are concerned, in theory they move in parallel with the inflation rates (which is why the interest rate parity formula is essentially the same). So when the dollar interest rate is lower then the exchange rate is lower and the euro will have therefore depreciated.
For a full explanation of why this is happening, watch my free lecture on forecasting foreign exchange rates.
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