Question

Find the real exchange rate in the following situations:                                                                    (Use the exchange rate as foreign per domestic, e(f/d) and e^r(f/d). Be sure to write the complete exchange rate including the number and origin of baskets. You may leave the answer as a fraction.)

US is the domestic economy; Canada is the foreign economy. The nominal exchange rate between US dollars and Canadian dollars is e(CAD/USD) = 1.2. The price of a US basket of goods is 200USD and the price of a similar Canadian basket is 300CAD.

The real exchange rate is ________________

The basket is cheaper in ____________

Pakistan is the foreign economy; Europe is the domestic economy. The nominal exchange rate between the Euro and the Pakistan Rupee is e(PKR/EUR) = 140. The price of a European basket of goods is 300 EUR and the price of a similar Pakistani basket is 40,000PKR.

The real exchange rate is ______________ ______

The basket is cheaper in _____ _______ ______

Answer 1

a) Real exchange rate is given by nominal exchange rate*( price in US / price in Canada )

real exchange rate = 1.2 (200/300)= 240/300 = 0.8

(since ae are given exchange rate in terms of CAD/ USD , we take home country in numerator )

The cheaper basket would be found out when both the baskets are comparable ie we acn compare them by converting into same currency

we are given the exchange rate of cad/$ as 1.2

so finding the price of US basket in CAD terms , we simply multilpy the nominal exchange rate by the US price of basket

$200*1.2 = 240 CAD

so basket is cheaper in US dollar

b) Real exchange rate is given by nominal exchange rate*( price in euro / price in pakistan )

= 140*(300/40000)= 1.05

Using the same formula as used in a) for finding the cheaper basket ,

The cheaper basket would be found out when both the baskets are comparable ie we can compare them by converting into same currency

we are given the exchange rate of  e(PKR/EUR) = 140.

so finding the price of EURO basket in Pakistan terms , we simply multilpy the nominal exchange rate by the EURO price of basket

so 300 *140 = 42000 PKR

hence by comparing these two we get that the basket is cheaper in Pakistan .