Assume that the spot exchange rate of the British pound is $1.73. This spot rate will adjust to according to PPP if the United Kingdom experiences an inflation rate of 7 percent while the United States experiences an inflation rate of 2 percent.

$1.64

Explanation:

Purchasing power parity (PPP) theory simply states that given two countries, exchange rate between them is equal to ratio of the level of prices in the two nations. This is also called absolute purchasing power parity (APPP).

When inflation between the two countries is considered, it becomes to relative purchasing power parity (RPPP). The RPPP states that there will be change in the exchange rate between the two countries when there are differences in inflation rates and prices of commodities in the two countries.

From the question, the difference of 5 percent (i.e. 7 percent - 2 percent = 5 percent) will result in the depreciation the spot exchange rate of the British pound as calculated below:

New spot exchange rate = Old spot exchange rate × (1 - inflation differential)

                                          = $1.73 × (1 - 0.05)

                                          = $1.73 × 0.95

                                          = $1.6435  approximately $1.64

Therefore, the spot rate will adjust to $1.64.

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