2. Large scale wars often result in a suspension of trade, making exchange rates irrelevant. Assume that you are the finance minister of country A (whose currency is the peso) and, as a war is ending, you want to calculate the exchange rate that will prevail against country B's currency (the dollar) when international trade in goods, services, and assets resume. You have the following information: At the onset of the war, both countries had a common nominal interest rate of 10%. At then end of the war, country A's interest rate hasrisen to 20%, while country B's interest rate is unchanged at 10%. A year ago, the exchange rate was 100 pesos to the dollar. Since then, prices have risen 25% in country A and 15% in country B. You expect both countries to have inflation of 5% per year after the war.
Calculate the exchange rate you expect to prevail under the following circumstances: (i) You are undertaking this analysis in 1965 (i.e. before the interest parity condition was known about, so that your only guidance to determining what the exchange rate will be is the theory of PPP). (ii) You are undertaking this analysis in 2005 and can make use of both interest parity and PPP.
(i)  If PPP is the only thing assumed to matter, then only changes in the relative price level figure into the calculation.  If PPP held at the start of the war, then the price of a basket of goods that cost $1 in country B must have been 100 pesos in country A. At then end of the war, the same basket of goods costs $1.15 in country B and 125 pesos in country A. To equate prices across countries, the exchange rate must be 125/1.15 = 108.7 pesos to the dollar.
(ii) Interest rate parity says that  the exchange rate today depends on the two interest rates and the expected exchange rate. We use PPP to determine the expected exchange rate, so we anticipate that it will be 108.7 pesos to the dollar in the future. Thus, using the formula for interest parity, we have (1+i)=Ee(1+i*)/E, we have E=108.7(1+0.10)/(1+0.20)=99.6 pesos to the dollar. Because the interest rate is higher in country A, we know that its currency must depreciate as it moves toward PPP in the next period. This requires that the peso be overvalued relative to its long-run equilibrium.