Question

A basket of goods costs £2,000 in the UK and the same basket costs ¥300,000 in Japan. If E¥/£ = 160, what is the real exchange rate of yen against pound? Does the PPP hold? Explain

Answer 1

According to the formula of Real Exchange Rate of yen(¥) against pound(£) is

e = E¥/£.(Pf/Ph)..............(1)

Where,

e = Real exchange rate.

E¥/£ = Nominal exchange rate.

Pf = Average cost of a basket of goods in foreign country (Japan).

Ph = Average cost of a basket of goods in home country (UK).

Now, we are told that, a basket of goods costs £2,000 in the UK and the same basket costs ¥300,000 in Japan.

Hence, we are given,

Pf = ¥300,000 and Ph = £2000

Also, E¥/£ = 160

Putting these values in equation (1) we get

e = 160×(2000/300,000)

or, e = 1.067

The real exchange rate of yen against pound is 1.067.

Now, PPP holds only when real exchange rate is unity or e = 1. But here e > 1. Hence, the PPP does not hold.

PPP does not hold here.

Hope the solutions are clear to you my friend.