Consider a basket of consumer goods that costs $72.00 in the United States. The

Question

Consider a basket of consumer goods that costs $72.00 in the United States. The same basket of goods costs 224.00 pesos in Mexico. The nominal exchange rate is 14.00 pesos per dollar. The real exchange rate between U.S. and Mexican baskets of goods is baskets of Mexican goods per basket of U.S. goods. Now suppose the nominal exchange rate increases from 14.00 pesos per dollar to 28.00 pesos per dollar. If the prices of the basket remain unchanged in both the United States and Mexico, the real exchange rate between the U.S. and Mexican baskets of goods will to baskets of Mexican goods per basket of U.S. goods.

Explanation / Answer

Real Exchange Rate (RER) = (Nominal exchange rate) x (Price of foreign basket) / (Price of domestic market)

When nominal exchange rate is 14.00:

RER = 14.00 x 224 / 72

RER = 43.55

When nominal exchange rate increases to 28.00:

RER = 28.00 x 224 / 72

RER = 87.11

The real exchange rate between the U.S. and Mexican basket of goods is 43.55 baskets of Mexican goods per basket of U.S. goods. Now suppose the nominal exchange rate increases from 14.00 pesos per dollar to 28.00 pesos per dollar. If the prices of the basket remain unchanged in both the United States and Mexico, the real exchange rate between the U.S. and Mexican baskets of goods will rise to 87.11 baskets of Mexican goods per basket of U.S. goods.

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