A. Compute the real exchange rate the cost of living in the US relative to that

Question

A. Compute the real exchange rate the cost of living in the US relative to that is the UK given the following information: Pus = $240, Puk= 200 pounds, Epound/dollar = 0.75 pound/dollar

B. interpret the meaning of the real exchange rate you computed in part A. According to the theory of absolute Perchasing Power parity, which country's cuttency is overvalued?

C. Suppose that the real exchange rate you computed in part A were to increase. What would we expected to happen to the US current accound, assuming that the Marshall-Lernet condition holds? explain.

Explanation / Answer

1. Pus = $240, Puk= 200 pounds, Epound/dollar = 0.75 pound/dollar

The real exchange rate the cost of living in the US relative to that is the UK = (nominal exchange rate X domestic price) / (foreign price) = (0.75*240)/ (200) = 0.9

2. The real exchange rate tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country

Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a market "basket of goods" approach.

The relative version of PPP is calculated:

S= p1 / p2

Where:

"S" represents exchange rate of currency 1 to currency 2

"P1" represents the cost of good "x" in currency 1 = 200 pounds

"P2" represents the cost of good "x" in currency 2 = $250

S = 200/250 = 0.8

Dollars to pound = 1.25

Exchange rate = 1/.75 = 1.33dollar/pound         

the exchange rate of dollars to pounds is any greater, which state that the pound is overvalued.

3. As the exchange rate increases the domestic currency devalues and so the imports become more expensive and exports become cheaper due to the change in relative prices.

Initially, there will be a deterioration of the trade balance which can be attributed to lags in recognition of the changed situation, lags in the decision to change real variables, lags in delivery time, lags in replacement of inventories and materials and lags in production.[2] These lags ensure that the demand for exports remains inelastic in the short term. In the long-term though, when the prices become flexible, there will be a positive quantity effect on the balance of trade because domestic consumers will buy fewer imports and foreign consumers will buy more of our exports; but offsetting this is a negative cost effect on the balance of trade, since the relative cost of imports will be higher. Whether the net effect on the trade balance is positive or negative depends on whether or not the quantity effect outweighs the cost effect; if the quantity effect is greater, then it is said that the Marshall–Lerner condition is met. Essentially, the Marshall–Lerner condition is an extension of Marshall's theory of the price elasticity of demand to foreign trade.

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