In January 2004 (when FC3 = $1) it was expected that by the end of 2004 the price level in the United States would have risen by 10% and in the foreign currency by 5%. The real rate of interest in both countries is 4%.
(a) Use the PPP to project the expected FCs per $1 at the end of 2004 (the expected future spot rate of FCs 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 IRP to estimate the current one-year forward rate of FCs 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 IRP guarantee consistency with the PPP relation when real interest rates in the different countries are equal? (Assume that all the fundamental relations hold.)