1. Suppose that in a given year, inflation in the US is 4 percent and inflation
ID: 1130846 • Letter: 1
Question
1. Suppose that in a given year, inflation in the US is 4 percent and inflation in Canada is 1 percent. If there is no change in the nominal exchange rate between Canada and the US, which country has a real appreciation, and by how much?
Can one use this equation to answer this question? or no?
% REa/b = % Ea/b - inflation a + inflation b
Canada inflation (a) = 1%
US inflation (b) = 4%
Nominal Ea/b = 0
% REa/b = 0 - 1 + 4
% REa/b = 3 %
But does this mean that there was a depreciation for canada and an appreciation for the US?
Explanation / Answer
Consider there are 2 countries “H=home” and “F=foreign”, now the nominal exchange rate is given by “E(H/F)”, => it shows the price of the foreign currency in terms of home currency.
The following relationship should hold good.
=> P = E(H/F) X P*, where P=Home Price and P*=Foreign Price.
=> The “Real Exchange Rate, R(H/F)”, is given by, “R(H/F) = E(H/F) X [P* / P]”.
=> we can write the above equation in “%” form.
=> “(%change in R) = (%change in E) + (% change in P*) - (% change in P)”
If we assume “USA=Home” and “Canada=Foreign”, then “% change in P* = 1” and “% change in P = 4”.
=> “(%change in R) = 0 + 1 – 4 = (-3) < 0”, => So, Real Exchange rate will fall by “3%”, => “R(USA/CA) will appreciate by “3%”, or in other words we can say that “R(CA/USA)” will depreciate by “3%”.
So, we can use the above equation to get the "% change in R", mentioned in the question.
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