Question

6. Suppose prices in the U.S. increase. If euro prices are constant and with no change in the nominal exchange rate, the euro has undergone:
   1. Real appreciation
   2. Real depreciation
   3. Nominal appreciation
   4. Nominal depreciation
   5. None of these
7. According to PPP, what is the long-run relationship between inflation and the nominal exchange rate:
   1. Higher inflation leads to depreciation
   2. Ambiguous relationship-it depends on extend of the Fed’s response
   3. Higher inflation leads to appreciation

Answer 1

1. The exchange rate has important relationship to the price level because it represents a link between domestic prices and foreign prices.

Here we can take and example to understand:

Let the price in US be $100

Exchange rate = $1.5/£

Then the price in Euro= 100/1.5= 66.67

Now

If the domestic price increase from 100 to 110, the price in EURo will be :

110= 1.5 * x

X= 110/1.5= 73.33

So the price has increased, while the exchange rate remain same . This situation is called real depreciation.

So the ans. Is B

2.

Relative PPP says that the changes in exchange rate between two countries is equals to the difference between the inflation rates between the two countries. And higher the inflation , it will lead to increase in the absolute value of currency, but decrease the actual value, so higher inflation leads to depreciation.

So the answer is A.