Question

1. Consider the following data for the “home” country of Afar (whose currency is the Afarian pound, £); the “foreign” currency is the U.S. dollar ($):

2000    2006

E £20/$                 £22/$

Phome 100                    140

Pforeign         100                     110

1. Calculate the real exchange rate for 2000 and 2006.
2. Did the Afarian pound appreciate or depreciate in nominal terms? in real terms? Explain your answer intuitively.
3. What do you think has happened to Afar’s trade balance (E- Z) between 2000 and 2006?
4. Does (relative) purchasing power parity hold for Afar between 2000 and 2006? Why or why not?
5. What would the nominal exchange rate e have to be in 2006, in order for purchasing power parity to hold (i.e., to keep the real exchange rate constant at its 2000 level)?

Answer 1

1) Nominal exchange rate = £20/$

Real exchange rate = Nominal exchange rate * Home price level / Foreign price level = 22 * 140/110 = £28/$

2) The calculations above depicts that the Afrian pound has thus depreciated in both nominal as well as real terms; and on contrary the dollar value has increased both in nominal and real terms.

3) If the country's currency depreciates the imports would become cheaper for them. Therefore the trade balance of Afar for the years 2000 and 2006 depicts the improvement because the imports becoming cheaper in that particular country.

4) Since the relative purchasing power among the two nations is unequal to the difference between the nominal and real value of the currencies of the two nations, thus the purchasing power parity would not hold for Afar in these years

5) Real exchange rate at its 2000 level): [20 * 100/ 100] = 20

For the nominal: [140/100 * (x)] = 20

Thus nominal exchange rate must be £14/$