Question

(a) Suppose the only differences in Countries X, Y, and Z are those detailed in the table below.

	Country X	Country Y	Country Z
Inflation rate	1%	4%	8%
Nominal interest rate, 10 year government bonds	4%	9%	11%
Perceived risk of default	Low	Low	High

What ordering (strongest to weakest) should we expect will occur for the real exchange rate of the national currencies? Explain

Answer 1

Real interest rate in country X = 4%-1% = 3%

Real interest rate in country Y = 9%-4% = 5%

Real interest rate in country Z = 11% - 8% = 3%

Since the real interest rate is highest for country Y among all the three countries, so real exchange rate of country Y will be strongest. In between the country X and Z, the real interest rate is same, but risk profile of country X is relatively low in comparison to country Z, then country X will have the second strongest real exchange rate. Finally, the country Z will have the lowest real exchange rate values.

So, from strongest to lowest, the ranking will be country Y, X and Z.