Question

The Mexican peso is trading at 11 pesos per dollar. If the expected U.S. inflation rate is 1% while the expected Mexican inflation rate is 15% over the next year, given PPP, what is the expected exchange rate in one year?

Short answer

The expected exchange rate in one year is 12.52 pesos per dollar.

Step-by-step solution

Concept Introduction 

Purchasing Power Parity means the rate between two countries is adequate to the ratio of the 2 countries price index of a set basket of products and services and it's also use to match the income levels worldwide. To calculate Purchasing Power Parity, inflation differences and price of living are taken under consideration. The Purchasing Power Parity makes it easy to grasp and interpret the information of every country.

Explanation of solution

Exchange rate of M pesos and US dollar is 11 pesos per dollar.

Inflation in US and M are $1\%$and$15\%$ respectively.

The formula to calculate the exchange rate is:

$\text{Exchange Rate}\left(e^t\right)=\frac{\text{Foreign pricelevel}\left({\mathrm{P}}_t\right)}{\text{DomesticPricelevel}\left({\mathrm{P}}_{\mathrm{d}}\right)}$

$$\begin{gathered} Calculationofexpectedexchangerate: \\ Expectedexchangerateinoneyear=11\times \frac{1.15}{1.01}=12.52 \end{gathered}$$

Hence, the expected rate is $12.52$pesos per dollar. Inflation in M is over US which suggests that depreciation in M currency over one year.

When there's inflation within the economy it results in depreciation of the domestic currency and makes domestic goods cheaper for foreign markets.

Depreciation of currency means decrease within the value of domestic currency relative to foreign currency.

Depreciation of currency makes domestic goods cheaper relative to the foreign goods.