Sep 21, 2017 term paper 2

# IN JANUARY 19X0 (WHEN DM3 = \$1) IT WAS EXPECTED THAT BY THE END OF 19X0 THE PRICE LEVEL IN THE…

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In January 19X0 (when DM3 = \$1) it was expected that by the end of 19X0 the price level in the United States would have risen by 10% and in West Germany by 5%. The real rate of interest in both countries is 4%.

a) Use the PPPT to project the expected DMs per \$1 at the end of 19X0 (the expected future spot rate of DMs per \$1).

b) Use the Fisher relation to estimate the nominal interest rates in each country that make it possible for investments in each country to earn their real rate of interest.

c) Use the IRPT to estimate the current one-year forward rate of DMs per \$1.

d) Compare your estimate of the current forward rate in (c) with your estimate of the expected future spot rate in (a).

e) Prove analytically that the Fisher effect and the IRPT guarantee consistency with the PPPT relation when real interest rates in the different countries are equal. (Assume that all the fundamental relations hold.)

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