1)Suppose that inflation in the US is 2 percent and 10 percent in Mexico. Suppose Mexico...

1)Suppose that inflation in the US is 2 percent and 10 percent in Mexico. Suppose Mexico is expected to experience a 5% real depreciation against the US. What is the expected rate of nominal appreciation or depreciation of the peso relative to the dollar?

2) Consider a world with two countries, the United States and Europe.Prices are perfectly flexible and APPP holds at all times. The money supply at this moment in the United States is $1,000,000, real output in the United States is 1,000 baskets. The money supply at this moment in Europe is €500,000 and real output in Europe is 1,000 baskets.Nominal interest rates, and liquidity demand for money are the same in both countries.

- What is the exchange rate written in European terms?

- Suppose that European output expands to 2,000 baskets but nominal interest rates stay the same , what happens to the price level in Europe?

Solutions

Expert Solution

1) Given that the inflation rate in the US is 2 percent and the inflation rate in Mexico is 10 percent. Mexico is expects

a 5% real depreciation against the US. We know that real exchange rate is given by the nominal exchange

multiplied by the ratio of price in two countries. For growth rates in price levels, the formula turns % change in real

exchange rate = % change in nominal exchange rate + domestic inflation – foreign inflation 5% = % change in

nominal interest + 2% – 10%. This implies we expect a 13 percent nominal appreciation of US dollar against pesos

and a 13% nominal depreciation of pesos.

2) The money supply in the United States is M(US) = $1,000,000, real output in the United States is Y(US) = 1,000

baskets. Hence the price level in US is $1000. The money supply at this moment in Europe is M(E) = €500,000 and

real output in Europe is Y(E) = 1,000 baskets. Hence the price level is €500. Exchange rate in European terms is

given by = (1000/1000)*(1000/500) = $2 per €. Now that European output expands to 2,000 baskets but nominal

interest rates stay the same. This implies the price level is (500,000)/2000 = €250

Rahul Sunny answered 1 year ago

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