A fund manager uses the concepts of purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot exchange rates. He gathers the financial information as follows:
A year ago, the spot rate between pound and dollar is $1.60/£. In the past year, US inflation is 3.5% and UK inflation is 4.5%. The current spot rate is $1.576/£.
a. What is relative PPP? Calculate the current pound spot rate in dollar that would have been forecast by PPP.
b. Does the PPP hold in this case? What could be the reasons for that?
c. What is IFE? If the expected US one-year interest rate is 0.5%, expected UK one-year interest rate is 0.75%, use IFE to predict the expected pound spot rate in dollar one year from now.