Textbook Problem

Assessing the Euro’s Potential Movements You reside in the United States and are planning to make a one-year investment in Germany during the next year. Because the investment is denominated in euros, you want to forecast how the euro’s value may change against the dollar over the one-year period. You expect that Germany will experience an inflation rate of 1 percent during the next year, whereas all other European countries will experience an inflation rate of 8 percent over the next Year. You expect that the United States will experience an annual inflation rate of 2 percent during the next year. You believe that the primary factor that affects any exchange rate is the inflation rate. Based on the information provided in this question, will the euro appreciate, depreciate, or stay at about the same level I against the dollar over the next year? Explain.