2. Large scale wars often
result in a suspension of trade, making exchange rates irrelevant.
Assume that you are the finance minister of country A (whose currency
is the peso) and, as a war is ending, you want to calculate the
exchange rate that will prevail against country B's currency (the
dollar) when international trade in goods, services, and assets resume.
You have the following information: At the onset of the war, both
countries had a common nominal interest rate of 10%. At then end of the
war, country A's interest rate hasrisen to 20%, while country B's
interest rate is unchanged at 10%. A year ago, the exchange rate was
100 pesos to the dollar. Since then, prices have risen 25% in country A
and 15% in country B. You expect both countries to have inflation of 5%
per year after the war.
Calculate the
exchange rate you expect to prevail under the
following circumstances: (i) You are undertaking this analysis in 1965
(i.e. before the interest parity condition was known about, so that
your only guidance to determining what the exchange rate will be is
the theory of PPP). (ii) You are undertaking this analysis in 2005 and
can make use of
both interest parity and PPP. |
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