Two countries, Britain & the U.S. produce just one good beef.  Suppose
that the price of beef in the U.S. is $2.80 per pound, and in Britain
it is {3.70 per pound.

a) According to PPP theory, what should the $ / { exchange rate be?
b) Suppose the price of beef is expected to rise to $3.10 in the U.S.,
and to {4.65 in Britain.  What should be the one year forward $ / {
exchange rate?
c) Given your answers to parts (a) & (b) and given that the current
interest rate in the U.S. is 10%, what would you expect current
interest rate to be in Britain?

Hi!!


a) According to PPP theory, what should the $ / £ exchange rate be?

PPP states that the exchange rate between one currency and another is
in equilibrium when their domestic purchasing powers at that rate of
exchange are equivalent:

Exchange rate ($/£) = US Price / UK Price =
                    = $2.80 / £3.70 =
                    = 0.757 $/£


b) Suppose the price of beef is expected to rise to $3.10 in the U.S.,
and to £4.65 in Britain.  What should be the one year forward $ / £
exchange rate?

According to PPP, the one year fordward exchange rate should be:

Exchange rate ($/£) = US Price / UK Price =
                    = $3.10 / £4.65 =
                    = 0.667 $/£


c) Given your answers to parts (a) & (b) and given that the current
interest rate in the U.S. is 10%, what would you expect current
interest rate to be in Britain?

Now we must use the following equation:

I(UK) - I(US) = (E1 - E2)/E2  

Where I is the interest rate for each country, E1 is the initial
exchange rate and E2 is the final exchange rate.

From the above equation we can isolate I(UK) that we want to know:

I(UK) = (E1 - E2)/E2 + I(US) =
      = (0.757 - 0.667)/0.667 + 0.10 =
      = 0.2349

The British interest rate is expected to be 23.49%

------------------------------------------------------

For references see:
"Chapter 30: Purchasing Power Parity"
http://internationalecon.com/v1.0/Finance/ch30/ch30.html


I hope that this helps you. Feel free to request for a clarification
if you need it.

Regards.
livioflores-ga