Describe and explain the relationship between expected inflation rates

Describe and explain the relationship between expected inflation rates in two countries and their interest rate differential according to the PPP theory.

What will be an ideal response?

ANSWER

Expected inflation is given by the following equation:
Πe = (Pe – P)/P where Pe is the expected price level in a country a year from today.
If relative PPP is expected to hold then:
( – )/ –
Combine the expected version of relative PPP with the interest parity condition:
R$ = + ( – )/
Rearrange:
R$ – = –
If, as PPP predicts, currency depreciation is expected to offset international inflation difference, the interest rate difference must equal the expected inflation difference.