Question

11. Suppose that apples were the only good produced in the United States and Mexico. In Mexico, apples sell for 12 pesos apiece. In the Unites states, apples sell for $0.50 apiece.

a. According to the theory of Purchasing Power Parity, what is the equilibrium nominal exchange rate between the U.S. dollar and the Mexican peso? What would the real exchange rate between the U.S. and Mexico in that case?

b. Suppose the price of apples rises at a rate of 3% per year in the U.S., but at a rate of 12% per year in Mexico. According to PPP, by how much should we expect the nominal U.S dollar/Mexican peso exchange rate to change in the course of 1 year (up, or down, and by what %)?

c. Starting at the exchange rate you calculated in (a), and assuming the rates of inflation remain the same as in (b), what nominal exchange rate would you expect in 3 years?

Answer 1