Suppose the exchange rate adjusts so that interest-rate parity holds. Also assume that the interest rate on a one-year Canadian bond is 3 percent and the interest rate on a one-year U.S. bond is 5 percent.
a.If the exchange rate today is 1.40 Canadian dollars per U.S. dollar, what do you expect the exchange rate to be one year from now? b.Suppose relative purchasing-power parity holds, and the inflation rate in Canada is expected to be 1 percent over the next year. What is the expected inflation rate in the United States?
What will be an ideal response?
iC = 3%; iUS = 5%. Interest-rate parity implies iUS = iC? %?Xe; note that the equation must be written this way because the exchange rate is written in Canadian dollars per U.S. dollar.
| a. | By the interest-rate parity equation: |
| iUS = iC? %?Xe. | |
| So, 5% = 3% ? %?Xe. | |
| So, %?Xe = ?2%. | |
By definition:  . | |
| If the exchange rate today is 1.4 Canadian dollars/U.S. dollars, then | |
 . | |
So,  . | |
So,  . | |
| b. | If relative purchasing-power parity holds, then %?X = ?C??US. |
| Since %?Xe = ?2% = 1% ??US, then ?US = 3%. |
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