Question

Let S = 0.90, the current exchange rate $ / €, P = 3 € the price level of goods in the domestic economy denominated in the currency of the country, P * = 2 $ the price level of the foreign economy in the currency of that country .
(i) Find the real exchange rate in terms of foreign product units per domestic product unit.
ii) If the domestic price level rises by 3% while the foreign one does not change, what is the new real exchange rate?
(iii) If inflation in the EU increases by 3% and the nominal exchange rate is also reduced by 3%, what is the new real exchange rate?
(iv) If domestic inflation rises by 5%, foreign by 3% and nominal rate by 1%, what is the new real exchange rate?

Answer 1

(i).

We have:

Real exchange rate (R):

(ii).

If the domestic price level rises by 3%, we have:

(iii).

If inflation in the EU increases by 3% and the nominal exchange rate is also reduced by 3%, we have:

(iv).

If domestic inflation rises by 5%, foreign by 3% and nominal rate by 1%, we have:

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