Question

1a.Suppose the nominal exchange rate between the US dollar and the Canadian dollar is 1.25 (1 US dollar can buy 1.25 Canadian dollars).

If the price of a basket of goods in the US is 150 USD and in Canada is 175 CAD, then find out the real exchange rate between the US and Canada.

1b. Interpret the value of the real exchange rate

2. Again suppose the nominal exchange rate between the US and Canada is 1.25 (1 US dollar can buy 1.25 Canadian dollars). Let the purchasing power parity condition be between the US and Canada holds true. If the price of a Ford is 35,000 USD, the find out the price of the Ford in Canada in terms of Canadian dollars

Answer 1

1a. Given: exchange rate between U.S. and Canada= 1.25

That is $1= CAD 1.25

Price of a basket of goods in the U.S.= 150 USD

Price of a basket of goods in Canada= 175 CAD

Real Exchange Rate between U.S. and Canada= Price of a basket of goods in US in CAD/Price of a basket of goods in Canada in CAD

Now, value of 1USD in terms of CAD= 1.25

So, the price of a basket of goods in the U.S. in CAD= 150*1.25

= 187.5 CAD

Therefore, real exchange rate= 187.5/175

=1.071

Hence, the real exchange rate between the U.S. and Canada is 1.071

1b. Real exchange rate compares the relative price of the basket of goods of two countries.

In the first part, real exchange rate between the U.S. and Canada is 1.071. This means that the U.S. basket of goods can be exchanged for 1.071 Canadian basket of goods