Problem:
You are given the following information. The current dollar-pound exchange rate is $2 per pound. A U.S. basket that costs $100 would cost $120 in the United Kingdom. For the next year, the Fed is predicted to keep U.S. inflation at 2% and the Bank of England is predicted to keep U.K. inflation at 3%. The speed of convergence to absolute PPP is 15% per year.
Required:
Question 1: What is the expected U.S. minus U.K. inflation deferential for the coming year?
Question 2: What is the current U.S. real exchange rate qUS/UK with the United Kingdom?
Question 3: How much is the dollar overvalued/undervalued?
Question 4: What do you predict the U.S. real exchange rate with the United Kingdom will be in one year's time?
Question 5: What is the expected rate of real depreciation for the United States (versus the United Kingdom)?