Question

Suppose that in December 2005, the euro exchange rate with the RON (the Romanian currency) is 0.2620 €/RON. Over the year 2006, the Romanian inflation rate is 9.7%, and the Euro area inflation rate is 2%. If the exchange rate at the end of the year 2006 is 0.2735 €/RON, does the RON appear to be overvalued, undervalued, or at the PPP level? Explain. What if instead Romanian inflation were 2% and the Euro area inflation rate were 10% over the year? Explain why your answer changes.

Answer 1

Option-1)

The inflation differential is given by 9.7% - 2 % = 7.7% or 0.077

Thus indicates that to maintain the exchange rate at the PPP level, we need to expect a 7.7% depreciation

(0.2735 - 0.2620) / 0.2620 = 4.4% or 0.044

Thus Ron is overvalued

Option-2)

The inflation differential is given by 2% - 10% = -8% or 0.08

Thus indicates that to maintain the exchange rate at the PPP level, we need to expect a 2% depreciation of the euro

(0.2735 - 0.2620) / 0.2620 = 4.4% or 0.044

Thus Ron is undervalued