3. Real versus nominal exchange rate Aa Aa Consider a basket of consumer goods.

Question

3. Real versus nominal exchange rate Aa Aa Consider a basket of consumer goods. The basket of goods costs $80.00 in the United States. The same basket of goods costs 12.80 pounds in Scotland. The nominal exchange rate is 0.80 pounds per dollar. If an individual has $80.00, he can convert it into pounds. With this amount of pounds, he can purchase baskets of Scottish goods. Therefore, the real exchange rate between the U.S. and Scottish baskets of goods is baskets of Scottish goods per basket of U.s. goods. If the nominal exchange rate decreases from 0.80 pounds per dollar to 0.40 pounds per dollar and if the prices of the basket remain unchanged in both the United States and Scotland, the real exchange rate between the U.S. and Scottish baskets of goods will to baskets of Scottish goods per basket of U.s. goods. rise fall

Explanation / Answer

Nominal exchange rate =0.8 pounds/dollar, If individual has $80 then $80*(0.8)=64 Pounds

Basket Value in Pounds is $12.8 therefore he can buy 5 baskets of Scottish goods

Real Exchange Rate is 5 baskets in Scottish Pound per basket of US goods

If Nominal exchange rate decreases from 0.8 pounds/ dollar to 0.4 pounds/dollar then cost of basket in pounds will be 0.4(80)=32 pounds

He can buy 32/12.8=2.5 baskets

Real Exchange Rate is 2.5 baskets in Scottish Pound per basket of US goods

Hence Real exchange rate will fall

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