The spot exchange rate is H1 = $2.00, where H is the home currency (one unit of H buys $2.00). Annual inflation is expected to be 6% in the home country and 2% in the USA. Using the exact purchasing power parity formula (not the approximation based on the inflation differential), what is the expected exchange rate in one year's time (to four decimal places)?

Correct answer: C) H1 = $1.9245

Explanation

Under PPP the currency with higher inflation depreciates. Exact formula: expected rate = spot x (1 + US inflation) / (1 + home inflation) = 2.00 x 1.02 / 1.06 = $1.9245 per H1 (rounded to four decimal places). $1.9200 uses the approximate 4% inflation differential, which the question excludes, and $2.0784 and $2.0800 apply the inflation rates the wrong way round (exactly and approximately respectively).