Question

(a) Define real exchange rate.

(b) If the price levels (indices) in Canada and the U.S. are 125 and 110 respectively, what is the PPP rate for the U.S. dollar? If prevailing spot rate is C$1.20/$, what is the real exchange rate of the U.S. dollar? Which currency is overvalued/undervalued in PPP terms?

Answer 1

A. Real exchange rate will be the exchange rate after comparing of the level of the consumption and the level of the exchange rate in the two countries. Real exchange rate will be comparing the relative price of two countries consumption basket.

B. PPP rate= (125/110)= 1.25 Canadian Dollar.

Real Exchange rate=( nominal exchange rate*price of foreign basket)/price of domestic basket)

=( 1.20*125/110)

= 1.36

United States dollars is undervalued in Canadian dollar is overvalued in in normal terms.