You are given the following information. The current dollar–pound exchange rate is $2 per British pound. A U.S. basket that costs $100 would cost $120 in the United Kingdom. For the next year, the Fed is predicted to keep U.S. inflation at 2% and the Bank of England is predicted to keep U.K. inflation at 3%. The speed of convergence to absolute PPP is 15% per year.
a. What is the expected U.S. minus U.K. inflation differential for the coming year?
b. What is the current U.S. real exchange rate, qUS/UK, with the United Kingdom?
c. How much is the dollar overvalued/undervalued?
d. What do you predict the U.S. real exchange rate with the United Kingdom will be in one year’s time?
e. What is the expected rate of real depreciation for the United States (versus the United Kingdom)?
f. What is the expected rate of nominal depreciation for the United States (versus the United Kingdom)?
g. What do you predict will be the dollar price of one pound a year from now?