Suppose the Japanese exchange rate is currently 105 yen per dollar. The inflation rate in Japan over the next three years will run, say, 2 percent per year, whereas the U.S. inflation rate will be 6 percent. Based on relative PPP, what will the exchange rate be in three years?

Because the U.S. inflation rate is higher, we expect that a dollar will become less valuable.

The exchange rate change will be 2 percent − 6 percent = − 4 percent per year. Over three years the exchange rate will fall to:

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E(S3) Sox [1 + (hFC-hus)]³ 105 x [1 + (-.04)]³ 92.90