Question

The current dollar−pound exchange rate is $2 per British pound. A U.S. basket that costs $100 would cost $140 in the United Kingdom. For the next year, the U.S. Fed is predicted to keep U.S. inflation at 2% and the Bank of England is predicted to keep U.K. inflation at 3%. The speed of convergence to absolute PPP is 15% per year.

1. (Scenario: Monetary Approach in the Long-run) What is the current U.S. real exchange rate with the United Kingdom? A) 1.4 B) 0.8 C) 0.71 D) 1.2

2. (Scenario: Monetary Approach in the Long-run) What do you predict the U.S. real exchange rate with the United Kingdom will be in one year’s time? A) 1.34 B) 0.86 C) 1.17 D) 1.2

3. (Scenario: Monetary Approach in the Long-run) What is the expected rate of real
depreciation for the U.S. (versus the United Kingdom)?
A) -4.3%.
B) -2.5%
C) -3%
D) -1%.

4. (Scenario: Monetary Approach in the Long-run) What is the expected rate of nominal
depreciation for the U.S. (versus the United Kingdom)?
A) -3.5%
B) -1.3%
C) 0.5%.
D) -5.3%

5. (Scenario: Monetary Approach in the Long-run) What do you predict will be the
dollar price of one British pound a year from now?
A) $1.5
B) $1.89
C) $1.93
D) $2

Answer 1

1) (Scenario: Monetary Approach in the Long-run) What is the current U.S. real exchange rate with the United Kingdom?

Solution: 1.4

Explanation: 140/100 = 1.4

2) (Scenario: Monetary Approach in the Long-run) What do you predict the U.S. real exchange rate with the United Kingdom will be in one year’s time?

Solution: 1.34

Explanation: 1.4 - 0.06*= 1.34; (=$2*3% = 0.06*)

3) (Scenario: Monetary Approach in the Long-run) What is the expected rate of real
depreciation for the U.S. (versus the United Kingdom)?
Solution: -4.3%

Explanation: Rate of convergence: 15% = each year the exchange rate will adjust by 15% of what is required to achieve an equilibrium fx rate of 1. Thus the next year, prices needs to adjust by 15% which equals a real exchange decrease of 0.03

4) (Scenario: Monetary Approach in the Long-run) What is the expected rate of nominal
depreciation for the U.S. (versus the United Kingdom)?

Solution: -5.3%

Explanation: Inflation differential + Expected real depreciation = -1% + -4.3%= -5.3%

5) (Scenario: Monetary Approach in the Long-run) What do you predict will be the
dollar price of one British pound a year from now?

Solution: $1.89

Explanation: $2*5.3% = 0.106; $2- 0.106 = $1.89