Assume: The current dollar-euro exchange rate E is $1.32 per euro. A U.S. basket

that costs $120 would cost 100 in the Eurozone. For the next year, U.S. inflation is

expected to be 6% and Eurozone inflation is expected to be 1%.

a. What is expected U.S. minus Eurozone inflation (pUS - pEUR) in the next year? [1]

b. What is the current U.S. real exchange rate (q) with the Eurozone? (price of

Eurozone basket relative to U.S. basket) [1]

c. Based on PPP, by how much (in % terms) is the dollar undervalued versus the

euro (i.e., by what percentage is q bigger than 1)? [2]