The current exchange rate between the Japanese yen and the U.S. dollar is 115 ye

Question

The current exchange rate between the Japanese yen and the U.S. dollar is 115 yen per dollar. At current prices, a basket of goods that costs $100 to produce in the U.S. would cost ¥10,500 to produce in Japan.   Over the coming year, the inflation rate in Japan is expected to be -1%, while the inflation rate in the U.S. is predicted to be 2%. The speed of convergence in the real exchange rate to PPP is 50% per year.

1-What do you predict the real exchange rate will be one year from now?

2-What do you predict the yen per dollar nominal exchange rate will be in one year?

Explanation / Answer

Solution :

At current prices exchange rate e = $ price of a standard market of goods / ¥ price of the same standard basket

e = $ 100 / ¥10,500

e = 0.00952

One year from now , the inflation rate is US is expected to be 2% . Therefore the same basket of goods will cost $ 102 in the US

Also one year from , the inflation rate in Japan is expected to be down by 1% . Therefore the same basket of goods will cost ¥ 10,395

The exchange rate after 1 year = $102 / ¥ 10,395

The exchange rate after 1 year = 0.00981

1) The real exchange rate after 1 year will be high by 3.04 %

2) The yen per dollar nominal exchange rate will be less by 1% .i.e the Yen appreciates dollar by 1%

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