If the world price of tradables remains unchanged while the official exchange rate rises by 20 percent and domestic prices for nontradables rise by 50 percent,then the real exchange rate (as defined in the Australian model):
A) rises by 30 percent.
B) falls by 30 percent.
C) falls by 20 percent.
D) rises by 70 percent.

Question

Quizplus · Accepted Answer

In the Australian model, the real exchange rate is calculated as the ratio of the price of nontradables to the price of tradables, multiplied by the nominal exchange rate.

Given that the world price of tradables remains unchanged, the ratio of the price of nontradables to the price of tradables increases as domestic prices for nontradables rise by 50 percent. This means that the real exchange rate falls.

Furthermore, since the official exchange rate rises by 20 percent, the nominal exchange rate increases. However, this increase is offset by the fall in the real exchange rate, resulting in a net decrease in the real exchange rate.

Therefore, the real exchange rate falls by 20 percent.

If the World Price of Tradables Remains Unchanged While the Official