Chapter 42, Problem 2CYU

a)

To determine

The real exchange rate now and for the next five years, if today's price index in both countries (U and M) is 100 by using the current year as the base year.

Explanation of Solution

Inflation in country U can be determined by:

  $\begin{array}{l}\frac{\text{Increased cost of market in country U}}{\text{Cost of goods and services in country U}}\\ =\frac{120}{100}\\ =1.2\end{array}$

Whereas, in country M, the inflation rate would be:

  $\begin{array}{l}\frac{\text{Increased cost of market in country M}}{\text{Cost of goods and services in country M}}\\ =\frac{1200}{800}\\ =1.5\end{array}$

Based on that, the real exchange rate is 10 because today's price index in both countries (U and M) is 100

Therefore, the real exchange rate for 5 years would be:

  $\begin{array}{l}\frac{\text{Real exchange rate }\times \text{ inflation in country M}}{\text{inflation in country U}}\\ =\frac{10\times 1.5}{1.2}\\ =12.5\end{array}$

Here, the real exchange rate for the next 5 years is 12.5.

Therefore, the real exchange rate is now 10 and the real exchange rate for 5 years would be 12.5

Economics Concept Introduction

Introduction: A global decentralized market for trading currencies is known as the foreign exchange market and for every currency, the foreign exchange rates are set by this market.

b)

To determine

The purchasing power parity for now and after 5 years.

Explanation of Solution

Purchasing power parity:

  $\begin{array}{l}\frac{\text{Cost of goods and services in country M}}{\text{Cost of goods and services in country U}}\\ =\frac{800}{100}\\ =8\end{array}$

Therefore, the purchasing power parity for this year is 8.

While the parity for 5 years would be:

  $\begin{array}{l}\frac{\text{Increased cost of market in country M in pesos}}{\text{Increased cost of market in country U in dollars}}\\ =\frac{1200}{120}\\ =10\end{array}$

Therefore, the purchasing power parity is now 8, and it would be 10 in 5 years from now.

Economics Concept Introduction

Introduction: A global decentralized market for trading currencies is known as the foreign exchange market and for every currency, the foreign exchange rates are set by this market.