- In July, the one‑year interest rate is 12% on British pounds and 9% on U.S. dollars.
- If the current exchange rate is $1.63:,1, what is the expected future exchange rate in one year?
b.Suppose a change in expectations regarding future U.S. inflation causes the expected future spot rate to decline to $1.52:£1. What should happen to the U.S. interest rate?
- If the current exchange rate is $1.63:,1, what is the expected future exchange rate in one year?
Answer. According to the international Fisher effect, the spot exchange rate expected in one year equals 1.63 x 1.09/1.12 = $1.5863.
b.Suppose a change in expectations regarding future U.S. inflation causes the expected future spot rate to decline to $1.52:£1. What should happen to the U.S. interest rate?
Answer. If rus is the unknown U.S. interest rate, and assuming that the British interest rate stayed at 12% (because there has been no change in expectations of British inflation), then according to the IFE, 1.52/1.63 = (1+rus)/1.12 or rus = 4.44%.
