theory of purchasing power parity
If the current exchange rate is US$1 equals 1.25 Euros, how
much did you win in US dollars?
Suppose that the interest rate in Irish banks is 5% for a
one year CD. In the USA, the rate is 2% for a one year CD. If you left your
winnings in Ireland, how many Euros would you have in a year? If you had taken
your winnings back to the USA, how many dollars would you have?
Suppose when you cashed in your CD in Ireland a year from
now, the exchange rate had changed from US$1 to 1.25 Euro, to US$1 to 1.30
Euro. How much would your Irish bank account be worth in US$ at that point? Did
you do better off leaving your winnings in Ireland or bringing them home to the
USA?
Explain how banks and individuals can use “covered
interest arbitrage” to protect themselves when they make international
financial investments.
Using the theory of purchasing power parity, explain how
inflation impacts exchange rates. Based on the theory of purchasing power
parity, what can we infer about the difference in inflation between Ireland and
the USA during the year your lottery winnings were invested? Show all
calculations
