[VanlayCPA]

am I the only person who seems to be completely befuddled by the currency exchange?

There’s a question that askes:
“The U.S. inflation rate is expected to be 5% per annum while the Italian lira is expected to depreciate against the U.S. dollar by 10% during the same period. During the next year, an Italian firm importing from its U.S. parent can expect its lira cost for these imports to:”

The answer:
“Taking the two events in order, if the inflation in the United States is expected to be 5%, then according to the purchasing power parity theorem of exchange rates, the exchange rate between the United States and Italy will increase by 5% (1 lira will increase in worth by 5% more dollars). On top of this expected inflation, is a 10% depreciation of the lira against the dollar, which will drive up the exchange rate another 10%, on top of the 5% inflation change. Mathematically we have:
$1.00 x 1.05 = $1.05 $1.05 x 1.10 = $1.155
Therefore, the price of imported goods to Italy will rise from $1.00 to $1.1550, an overall increase of about 15%.”

I cannot understand, for the life of me, why a 10% depreciation of the lira against the dollar causes the Lira to have more purchasing power against the dollar?? If the lira is depreciating against the dollar, doesnt that mean it is losing purchasing power against the dollar?

What am i missing here?

[Anonymous]

If goods are cheaper in Lira, there will be more demand for them from the US consumers….Thus more purchasing power…. Hope this helps!

[Author]

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