Question

The real exchange rate between the U.S. dollar and the Canadian dollar will remain constant if an increase in the value of the U.S. dollar against the Canadian dollar is offset by: A) inflation in the United States. B) inflation in Canada. C) worldwide deflation. D) inflation in the United States and in Canada.

Please explain

Answer 1

A) i) High inflation in the US means US goods increase in price quicker than Canadian goods. Therefore, Us goods become less competitive. Demand for US exports will fall, therefore there will be less demand for USD.

ii) Also, US consumers will find it more attractive to buy Canadian imports. Therefore, they will supply USD to be able to buy Canadian dollars and the Canadian imports. This increase in the supply of USD decreases the value of the USD. Therefore, in the long run if inflation occurs in the US then the real exchange rate = Prices level in Canada / Price level in the USA, as stated initially the price level in the USA will inceainc, thus the value of the whole fraction ie the real exchange rate will decrease, but eventually the value of the US dollar will decrease, thus the inflation in the US will offset the increase in the value of the USD over the Canadian dollar.

B) Here, as stated the price of US dollar has increased over the price of Canadian dollar, then the real exchangr rate should decrease. However, if inflation occurs in Canada, then Canadian goods will be expensive to buy than the US goods, hence at point in time the value of the Canadian dollar will decrease as there will be less demand of the Canadian dollars. Hence, the increase in the value of US dollar against Canadian dollar will offset the changes in the real exchange rate if inflation occurs in Canada.

C) If worldwide deflation occurs then US will start importing goods from other countries, thus the value of US dollar will reduce, hence, the real exchange rate between US and Canada will remain the same as the value of US dollar decreases.

D) Here, inflation occurs in both the countries but the price of USD exceeds the price of Canadian dollars. If inflation occurs both in the United States and in Canada, then on the increase in prices of USD over Canadian dollars, the export of US goods will decrease and the thus the value of USD will decrease eventually. The real exchange rate will this remain the same.