Question

If the initial exchange rate is $1.20 cad for $1.00US. After 10 years, the United States price level has risen from 100 to 200, and the Canadian price level has risen from 100 to 175.

What was the inflation rate in each country?

What nominal exchange rate would preserve the initial real exchange rate?

Which country’s currency depreciated?

Answer 1

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Initially, the exchange rate is => 1.20 CAD = 1.00 USD

1)

After 10 years, the United States price level has risen from 100 to 200,

Inflation rate in the USA = (2 - 1) / 1 = 1 = 100%

and the Canadian price level has risen from 100 to 175,

Inflation rate in the Canada = (2.1 - 1.2) / 1.2 = 0.75 = 75%

2)

The initial real exchange rate will preserve by the nominal exchange rate =

1.20 CAD = 1 USD

After 10 years 2.1 CAD = 2 USD

=> 1.05 CAD = 1 USD

3) USA currency is depreciated because 1USD is getting only 1.05CAD after 10 years instead of 1.20CAD.