In January 2012, one US dollar was worth 50 Indian rupees. Suppose that over tha

Question

In January 2012, one US dollar was worth 50 Indian rupees. Suppose that over that next year the value of the Indian rupee decreases to 60 Indian rupees to one US dollar. Suppose also that the price level of all goods and services in India, as measured in rupees, falls 20%, so that the Indian price index falls from a value of 100 to 80. At the same time, suppose that the US price level increases by 6%, to 106. By what percentage did the value of the real exchange rate change over this period? The exchange rate is expressed as the number of Indian rupees per US dollar. Please give your answer to the nearest whole percentage point. What will happen to the following as a result of the changes? America's consumption of Indian goods and services will likely... India's consumption of American goods and services will likely...

Explanation / Answer

Real exchange rate in 2012 = 50

Real exchange rate in 2013 = Nominal exchange rate * Domestic price level / Foreign price level

= (60 * 106) / 80

= 79.5

Change in the real exchange rate = 79.5 - 50 / 50 * 100 = 59 per cent.

Indian rupee has depriciated while dollar has appreciated. So, American consumption if Indian goods will rise as Indian exports will become cheaper and India's consumption of American goods will decrease.

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