The beginning-of-the-year prices for sunglasses are $30 in the United States and ¥5,000 in Japan. We know that prices in the United States and Japan will change over the coming year due to inflation
If we assume that inflation in the United States (our home country, infh) will be 3% and inflation in Japan will be 2% (our foreign country, inff), what will the price of the sunglasses be at the end of the year? If one U.S. dollar can be exchanged for ¥166.6667 Japanese yen today and purchasing power parity holds, what can we say about the future exchange rate one year from now?
What will be an ideal response?
Answer: U.S. Sunglasses Price = $30 × (1 + infh) = $30 × 1.03 = $30.90 and Japanese Sunglasses Price = ¥5,000 × (1 + inff) = ¥5,000 × 1.02 = ¥5,100. If we apply purchasing power parity at the end of the year, the exchange rate should be set for $ and ¥ so that end-of-the-year sunglasses prices reflect this exchange rate: $ to ¥ = = 0.006059 (direct), or ¥ to $ = = 165.048544 (indirect). The future exchange rate, or more properly, the forward indirect exchange rate one year from now, should decrease from 166.6667 to 165.0485.
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