exican spot exchange rate is 18.3 Mexico Peso per U. S. dollar. U. S. inflation is expected to be 2% per year, and Mexican inflation is expected to be 7% what is the expected exchange rate in year 3

21.2 Mexican pesos per 1 US dollar

Explanation:

The purchasing power parity state that the current equilibrium exchange rate is 18.3 Mexican pesos for 1 US dollar.

but if Mexico's inflation is 7% and US's inflation is only 2%, in one year the Mexican peso will be overvalued by 7% - 2% = 5%. In one year the equilibrium exchange rate should be 18.3 x (1 + 5%) = 19.215 Mexican pesos for dollar.

In two years the equilibrium rate should be 19.215 x 1.05 = 20.17575

In three years the equilibrium rate should be 20.17575 x 1.05 = 21.1845375, which we can round to 21.2 Mexican pesos per 1 US dollar.

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