Given the following hypothetical data on price indexes for the US and EU (Europe

Question

Given the following hypothetical data on price indexes for the US and EU (European Union), Assume that the nominal exchange rate R had stayed unchanged at $1.5 per in both 2009 and 2010. Explain whether the euro appreciated or depreciated in real terms against the dollar between 2009 and 2010. You must support your explanation with the real exchange rates you are to compute for both 2009 and 2010. Explain how the change in the real exchange rate indicates the change in the purchasing power of the dollar (relative to the euro) from 2009 to 2010. Suppose that the hypothesis of PPP holds in the long run. Then the PPP-determined nominal exchange rate could serve as a benchmark. Against this benchmark, you are asked to determine whether the nominal exchange rate of R = $1.5 per had under-valued or over-valued the euro in 2009 and 2010, respectively. You must compute the extent to which the euro was undervalued (or overvalued) in each year.

Explanation / Answer

a.

Euro appreciates

In 2009 real exr = 120/100=1.2$/E and

in 2010 real exr =165/105 =1.57$/E-         

so E has appreciated as we get more $ per E now in 2010

b.

in 2009 pp of $= 100/120 =0.833E/$

in 2010 pp of $ = 105/165 =0.636E/$

this shows that pp of $ has fallen. 1 $ now buys us less of E

c.

as per PPP exr in 2009 = 1.2$/E

as per PP exr in 2010 =1.57$/E

2009: comparing 1.2 with nominal rate of 1.5$/E we can say that E is overvalued

Extent of overvaluation = (1.5-1.2)*100/1.2 =25%

2010: comparing 1.57 with nominal rate of 1.5$/E we can say that E is undervalued

Extent of overvaluation = (1.5-1.57)*100/1.57 =-4.458%

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