In international exchange, parity refers to the exchange rate between the currencies of two countries making the purchasing power of both currencies substantially equal. Theoretically, exchange rates of currencies can be set at a parity or par level and adjusted to maintain parity as economic conditions change. On the other hand, Interest Rate Parity (IRP) is a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates.

a)Suppose the current spot rate in New York is 0.0107 dollars per yen. Inflation for the coming year in the United States is expected to be 5%, while inflation for the coming year in Japan is expected to be only 2%. Using the purchasing power parity theory, calculate the expected spot rate at the end of the year. (2 Marks)

b)The spot exchange rate in New York is 1.600 dollars per British pound. The 360-day forward exchange rate is 1.680 dollars per pound. The one-year interest rate in Great Britain is 2% while the one-year interest rate in the United States is 4%. If the interest rate in Great Britain remains at 2%, what should the interest rate be in the United States according to the interest rate parity theory? (2 Marks)