Suppose the spot exchange rate for the Hungarian forint is HUF 203.86. The inflation rate in the United States will be 1.2 percent per year. It will be 4.2 percent in Hungary. a. What do you predict the exchange rate will be in one year? b. What do you predict the exchange rate will be in two year? c. What do you predict the exchange rate will be in five year?

(1) Exchange Rate in 1 year = HUF 209.90 / $ (2) Exchange Rate in 2 years = HUF 216.12 / $ (3) Exchange Rate in 5 years = HUF 235.92 / $

Explanation:

Solution

Given that:

The Spot Rate = HUF 203.86 / $

This implies that 1 dollar is equivalent to 203.86 Hungarian Forint

Now

(1) The exchange rate in one year

The Purchasing power parity equation is shown below:

Thus

E (S1) / S0 = (1 + RA) / (1 + RB)

Here

E (S1) = Expected Spot Rate of Year 1

S0 = Current Spot Rate - 203.86

RA = Inflation Rate in Hungary - 4.2%

RB = Inflation Rate in United States - 1.2%

Hence

The Exchange Rate in 1 year will be:

E (S1) / S0 = (1 + RA) / (1 + RB)

E (S1) / 203.86 = (1 + 0.042) / (1 + 0.012)

E (S1) / 203.86 = 1.042 / 1.012

E (S1) = (1.042 * 203.86) / 1.012

E (S1) = 209.90

Exchange Rate in 1 year is HUF 209.90 / $

(2) The exchange rate in 2 years

Thus

E (S2) / S1 = (1 + RA) / (1 + RB)

E (S2) = Expected Spot Rate of Year 2

S1 = Spot Rate of Year 1 - 209.90

RA = Inflation Rate in Hungary - 4.2%

RB = Inflation Rate in United States - 1.2%

Hence

The exchange rate in 2 years is HUF 216.12 / $

(3) Exchange Rate in 5 years

The first step here is to compute the expected spot rate of year 3 and year 4 respectively

So,

E (S3) / S2 = (1 + RA) / (1 + RB)

E (S3) = Expected Spot Rate of Year 3

S2 = Spot Rate of Year 2 - 216.12

RA = Inflation Rate in Hungary - 4.2%

RB = Inflation Rate in United States - 1.2%

E (S3) = (216.12 * 1.042) / 1.012

E (S3) = 222.53

E (S4) / S3 = (1 + RA) / (1 + RB)

Now

E (S4) = Expected Spot Rate of Year 4

S3 = Spot Rate of Year 3 - 222.53

RA = Inflation Rate in Hungary - 4.2%

RB = Inflation Rate in United States - 1.2%

E (S4) = (222.53 * 1.042) / 1.012

E (S4) = 229.13

Thus

The exchange rate in year 5 is given below:

E (S5) / S4 = (1 + RA) / (1 + RB)

E (S5) = Expected Spot Rate of Year 5

S4 = Spot Rate of Year 4 - 229.13

RA = Inflation Rate in Hungary - 4.2%

RB = Inflation Rate in United States - 1.2%?

E (S5) = (229.13 * 1.042) / 1.012

E (S5) = 235.92

Therefore the exchange rate in 5 years is HUF 235.92 / $