6. Assume that the current dollar-Euro exchange rate (E$/€) is equal to 1.05, the real exchange rate (qus/Eur) = 1.26, the price level equals 1 in the U.S. and 1.2 in Europe. Assume that relative PPP holds.
a. If inflation is 4% in the U.S. but 1% in Europe, what will be the price levels in the U.S. and Europe a year from now?
b. Given your answer to part a, what will be the nominal exchange rate (E$/€) a year from now?
c. What will the real exchange rate be a year from now?
Soln : a) There is always a reverse relation between inflation and exchange rate of the countries, as inflation will increase the currency value depreciates.
Here in this case Exchange rate of $/euro = 1.05 i.e. 1Euro = $1.05 , US inflation = 4% and Euro inflation = 1%
Price level in US = 1*1.04 = 1.04 and in Europe = 1.2*1.01 = 1.212
Also, % change in exchange rate due to inflation difference = 4-1 = 3%
So ,we can say that now 1 Euro = 1.05*1.03 = 1.0815
(b) Nominal Exchange rate one year from now, 1Euro = 1.0815
c) Real exchange rate = Nominal Exchange rate * Price level in foreign/price level in domestic = 1.0815 *1.212/1.04 = 1.26
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