Question

At t0 the exchange rate is $1.00/£. At t1 the exchange rate is $0.9130/£. Over this period inflation increased 15 percent in the UK and 5 percent in the US. The real exchange rate at t1 is

Answer 1

At t1 the exchange rate is $0.9130/Pound.

Increase in Inflation = 15% in time t1-t0 in UK and 5% in US. Due to inflation the value of currency will depreciate for both countries but it will depreciate more in magnitude in UK. $0.9130 due to the impact of 5% inflation becomes 0.86735 in US. Pound 1 in UK becomes 0.85 pound due to15% inflation. Hence at exchange figure becomes 0.86735 dollar equals 0.85 pound; Hence, $1 = 0.85/0.86735 = 0.98 pound

Hence 1 pound = 1/.98 = 1.0204 dollar.

Therefore, the real exchange rate equals $1.0204/Pound sterling.