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Inflation differential for the coming year

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Reference no: EM131457001

Suppose that the current dollar-Euro exchange rate is $2 per Euro. A basket that costs $100 in the US would cost $120 in Germany. For the next year, the Fed is predicted to keep U.S. inflation at 2% and the European Central Bank is predicted to keep EU inflation at 3%. The speed of convergence to absolute PPP is 15% per year.

a. What is the expected U.S. minus EU inflation differential for the coming year?

b. What is the current U.S. real exchange rate, qUS/EU?

c. How much is the dollar overvalued/undervalued in real terms?

d. What do you predict the U.S. real exchange rate with the EU will be in one year's time? (hint: think about the rate of convergence to PPP... a rate of convergence of x% means that each year, the exchange rate adjusts by x% of what is needed to restore PPP (make real exchange rate = 1))

Reference no: EM131457001

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