7-1 Assume that the actual (nominal) exchange rate of the dollar to the British

Question

7-1 Assume that the actual (nominal) exchange rate of the dollar to the British pound ($/£) in 2017 = 1.47; the exchange rate $/£ for 2010 (the base year) = $1.60, price index (PI) US in 2017 = 154.5, and PI UK in 2017 = 148.8. (a) What is the real exchange rate in 2017? (3 points) (b) Did the US gain competitive advantage or disadvantage in the world market? (2 points) (c) What is the relative purchasing power parity PPPrel for $/£ in the year 2017? (4 points) (d) Was the dollar overvalued or undervalued in 2017? (2 points)

Explanation / Answer

AS per the given information,
actual (nominal) exchange rate of the dollar to the British pound ($/£) in 2017 = 1.47;
the exchange rate $/£ for 2010 (the base year) = $1.60,
price index (PI) US in 2017 = 154.5, and
PI UK in 2017 = 148.8.

Therefore,

a) Real exchange rate in 2017 will be given as actual (nominal) exchange rate 2017* (price index (PI) US in 2017/PI UK in 2017)
Thus, 1.47*(148.8/154.5) = 1.42

b) We have calculated above real exchange rate as 1.42 which means, the average consumer prices in Europe are 42 percent higher than in the United States therefore, we can conclude US gain competitive advantage in the world market.

c) The relative purchasing power parity PPPrel for $/£ in the year 2017 will be using the exchange rate $/£ for 2010 (the base year) = $1.60, price index (PI) US in 2017 = 154.5, and PI UK in 2017 = 148.8 therefore it will be 1.60*(148.8/154.5) = 1.54

d) As the relative purchasing power parity PPPrel for $/£ in the year 2017 is 1.54 (calculated above) We can say dollar was undervalued in 2017 as elative purchasing power parity PPPrel for $/£ > 1

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