Question

What is different about the relative price ratio and the exchange rate in terms of income? Explain it. If the price index in Euroland is 140 and the price index in US land is 100, while the exchange rate is 1.2 $/euro, i.,e., one euro buys one dollar and twenty cents. How does it alter ?

Answer 1

if price index in Euro land is 140 and in Us land is 100, it implies that prices are 40% higher in Euro land,

which indicates the person has to pay 40 more in Euro compared to dollar

now the exchange rate : 1.2$ = 1 euro, which has to change in such a way so that the prices balance in both the land

At present if you have 140 euros, it will be equal to 140 x 1.2 = 168 dollars

so person can buy 1 unit of commodity in 140 euros in Euro land, and person in US can buy 1.68 units of commodity in US land

so person recceived more in US currency terms or US is relatively cheaper

so $ has to depreciate to make balance in both the countries

so to effect that rate has to be = 1.2 x (price in US land /price in Euro land) = 1.2 x(100/140) = $ 0.8571/ Euro

So the rate will change from $1.2 / Euro to $0.8571/ Euro

Any doubts, please feel free to ask