Question

The current dollar−pound exchange rate is $2 per British pound. A U.S. basket that costs $100 would cost $140 in the United Kingdom. For the next year, the U.S. Fed is predicted to keep U.S. inflation at 2% and the Bank of England is predicted to keep U.K. inflation at 3%. The speed of convergence to absolute PPP is 15% per year.

1. (Scenario: Monetary Approach in the Long-run) What is the current U.S. real exchange rate with the United Kingdom?

A) 1.4 B) 0.8 C) 0.71 D) 1.2

2. (Scenario: Monetary Approach in the Long-run) What do you predict the U.S. real exchange rate with the United Kingdom will be in one year’s time?

A) 1.34 B) 0.86 C) 1.17 D) 1.2

Answer 1

1) The current US real exchange rate with the United Kingdom = 140 / 100 = 1.4 (A)

2) Convergence to absolute PPP is 15% , so each year exchange rate will adjust by 15% to reach the target : real exchange rate = 1 . Presently real exchange rate = 1.4 . So 0.4 decline is required to fulfill the condition of absolute PPP . 15% adjustment over a year would mean (2*15/100 ) = 0.03 decline in real exchange rate . So after one year real exchange rate will be = 1.4 - 0.03 = 1.37