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]

d. Assume that 20% (or 1/5) of the deviation from PPP (i.e., 20% of the difference

between q and 1) is eliminated each year through gradual adjustment (arbitrage). If

so, what would be the expected level of q one year from now? [2]

e. Based on the last answer, how much (in %) will the dollar be undervalued versus

the euro next year, assuming nothing else happens? And what is the expected rate of

change in q (i.e., what is Dq/q) from this year to next year? [2]

f. Given the expected rate of change in q (in part e), and the expected inflation

differential (in part a), what is the expected rate of nominal depreciation DE/E for

the dollar (versus the euro) for the coming year? [2]