Question

Suppose P (domestic price) and P* (foreign price) are both increasing. Now suppose that the dollar...

Suppose P (domestic price) and P* (foreign price) are both increasing. Now suppose that the dollar experiences a 5% nominal depreciation.

a. Which country is experiencing the higher rate of inflation if the domestic currency experiences a real appreciation? Briefly explain.

b. Which country is experiencing the higher rate of inflation is the domestic currency experiences a real depreciation? Briefly explain.

c. Compare the changes in P and P* if the real exchange rate does not change.

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Answer #1

1.

We know real exhcnage rate=nominal exhcnage rate*price in domestic/price in foreign

As nominal exchange rate is decreasing then price in domestic must increase at a faster rate compared to price in foreign to increase the real exchange rate. Hence, inflation in domestic or US is higher than inflation in foreign.

2.

As nominal exchange rate is decreasing tthen real exchange rate will decrease even if both have same inflation. Hence, we wont be able to comment on relative inflation in this case.

3.

If real exchange rate is constant then P/P* must be equal to 1/0.95=

1.052632
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