Question

1. What would happen to Bolivia’s real exchange rate in each of the following situations?
   1. The Bolivian nominal exchange rate is unchanged. Prices rise faster in other countries than in Bolivi (3 points)

2. The Bolivian nominal exchange rate increases. Prices rise faster in Bolivia than abroad. (3 points)

Answer 1

Real exchange rate (R) = Nominal exchange rate (N) x [Price level in Foreign countries (Pf) / Price level in Bolivia (Pb)], so

% Change in R = % Change in N + % Change in Pf - % Change in Pb

(a) When N is constant and Price rises faster in other (foreign) countries,

% Change in N = 0 and

% Change in Pf > % Change in Pb, therefore

% Change in R = (0 + % Change in Pf - % Change in Pb) > 0

So, real exchange rate will increase in Bolivia.

(b) When N is constant and Price rises faster in Bolivia,

% Change in N = 0 and

% Change in Pf < % Change in Pb, therefore

% Change in R = (0 + % Change in Pf - % Change in Pb) < 0

So, real exchange rate will decrease in Bolivia.