Suppose that in the beginning of the year, the exchange rate between US-dollar and the euro is exactly 2 $/EURO. At that time, a one-year US treasury bill yield an interest rate of 5%, while a similar German treasury bill yield 3%. Inflation during the year is expected to be 3% in the USA and 2% in the euro area.
(a) Use purchasing power parity (PPP) to forecaste the exchange rate between the dollar and the euro at the end of the year.
(b) Use uncovered interest parity (UIP) to forecaste the exchange rate between the dollar and the euro at the end of the year.
(c) Use covered interest parity (CIP) to compute the one-year forward exchange rate between the dollar and the euro at the beginning of the year.