1. a) Explain the theory of purchasing power parity (PPP). Based on this theory, what is a...

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Question:

a) Explain the theory of purchasing power parity (PPP). Based on this theory, what is a general forecast of the values of currencies in countries with high inflation?

b) Today’s spot rate of the Ghana Cedi is $0.22. Assume that purchasing power parity holds. The U.S. inflation rate over this year is expected to be 5 percent, while Ghana inflation over this year is expected to be 9.8 percent. E5 Company Ltd is a Ghanaian company and it plans to import from United States and will need 20 million US dollars in 1 year.

Determine the expected amount of cedis to be paid by the E5 Company Ltd for the US dollars in 1 year. (Please take Ghana as the home country).

a) Explain the international Fisher effect (IFE) theory. Explain why the IFE may not hold.

b) Assume that the Australian dollar’s spot rate is $.90 and that the Australian and U.S. one-year interest rates are initially 6 percent. Then assume that the Australian one-year interest rate increases by 5 percentage points, while the U.S. one-year interest rate remains unchanged. Using this information and the international Fisher effect (IFE) theory, forecast the spot rate for one year ahead. (2marks) c) According to the IFE, what is the underlying factor that would cause such a change in interest rate in (b) above?

If U.S. investors believe in the IFE, will they attempt to capitalize on the higher Australian interest rates? Explain.