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Dear Tutor,
Please can you clarify this for me because i have seen conflicting solutions to the issue.
CASE : Home (£) country plans to invest in Foreign country ($). Home country Inflation is 5% and Foreign Country is 12% . Spot Rate is $0.70 to £1.
PPP (year 1) = 1.12/1.05 X 0.70 (This i understand)
However supposing Home Country Inflation is 20% and Foreign Country Inflation is 7%. Spot Rate is the same as above.
PPP ( will this be correct as done in a Q & A solution i just practised? (PPP solution below)
PPP ( Year 1) = 1.20/1.07 X 0.70
Thanks
It would not be correct (it should be 1.07/1.20 x 0.7)
However, are you sure that you have read the question correctly?
The ‘home’ country is the one that the other currency is being quoted against.So if the quote is actually $0.70 to £1, the ‘home’ country is £’s and the ‘foreign’ country is $’s.
Thanks, I thought as much that the solution may be a typo error. PPP has ever been calculated as you correctly stated above whether the home currency inflation rate is higher or lower compared to the foreign currency inflation rate.
Please can i just ask, what happens if we are just told the home currency deflates by a constant rate (say 3%) and no other rate was given for the foreign currency, and vice versa?
Thanks
Deflation is no problem – the formula stays the same. 1 + (- 0.3) = 0.97
But if you do not know the inflation for the other country then you cannot calculate a precise figure.
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