Question

Suppose Country X has a currency called Riyal (R). At the beginning of the year, the exchange rate between Riyal and the U.S. dollar was R3.750/$. The inflation rate in Country X was running during the year at an annual rate of 10 percent, whereas the inflation in the U.S. was running at 2 percent.

a. Compute the new exchange rate between Riyal and the dollar at the end of the year. You must show the calculations to get credit.

b. Which currency had depreciated at the end of the year? Explain.

Answer 1

a) Inflation adjusted value of one Riyal (R) at the end of the year = R * (1-10%)

= 0.9 R

Inflation adjusted value of one $ at the end of the year = $ * ( 1-2%)

= 0.98 $

Exchange rate at the end of the year = (3.750/0.9)*.98

= R4.083/$

b) Riyal had depreciated in comparison to $ at the end of the year, because at the beginning of the year, one $ could be purchased for 3.750 Riyals, but at the end of the year, 4.083 Riyals needed to be spent to purchase one $