5. Suppose that the nominal exchange rate between the U.S. dollar and the Mexica

Question

5. Suppose that the nominal exchange rate between the U.S. dollar and the Mexican peso is 0.10 dollars per peso. If Mexico's inflation is 10 percent and the United States' inflation is 0 percent, from the U.S. point of view, the real exchange rate A) appreciates to 0.11 dollars per peso. B) depreciates to 0.11 dollars per peso. C) appreciates to 0.09 dollars per peso. D) depreciates to 0.09 dollars per peso. 6. If the nominal exchange rate does not change, but U.S. prices fall, the real exchange rate has and U.S. imports are likely to__. A) increased; rise B) increased; fall C) decreased; rise D) decreased fall

Explanation / Answer

Given that the nominal exchange rate between the US dollars and Mexican peso is 0.10 dollar per peso.

or Nominal Exchange Rate is as 1 Dollar = 10 Peso

Mexico's inflation rate = 10%

Thus, effective exchange rate or Real interest Rate becomes 1 Dollar = 10 Peso (1+0.1) = 11 Peso

or we have 1 dollar = 11 peso

or 1 Peso = 1/11 = 0.09 dollars

Thus, the real exchange rate depreciates to 0.09 dollars per peso.

6. One can define the Real exchange rate as under:

Real exchange rate = Nominal Exchange Rate / Price Level

Now, if Price level goes down, and Nominal exchange rate being the constant, it implies that the real exchange rate will also increase.

An increase in the real exchange rate implies that people can buy more of goods and services with the existing money they hold.

Thus, as a result, we can see real exchange rate will increase and the imports are likely to decrease because we get more of domestic goods at lower price.

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