As of November 1, 1999, the exchange rate in between the Brazilian real and U.S. dollar is R$1.95/$. The agreement forecast for the U.S. and Brazil inflation rates for the next 1-year period is 2.6% and 20.0%, correspondingly. How would you forecast the exchange rate to be at just about November 1, 2000?

Solution: As the inflation rate is quite high in Brazil, we may make use of the purchasing power parity to forecast the exchange rate.

                    E(e)    = E(p_$) - E(p_R$)

                              = 2.6% - 20.0%

                              = -17.4%

                    E(S_T)  = S_o(1 + E(e))

                              = (R$1.95/$) (1 + 0.174)

                              = R$2.29/$