If the annual inflation rate is 5.5 percent in the United States and 4 percent in the U.K.,and the dollar depreciated against the pound by 3 percent,then the real exchange rate,assuming that PPP initially held,is

Question

Quizplus · Accepted Answer

The formula for calculating the real exchange rate is:

Real exchange rate = (Nominal exchange rate x Domestic price level) / Foreign price level

Assuming PPP initially held, the nominal exchange rate would be equal to the ratio of the U.S. and U.K. price levels:

Nominal exchange rate = U.S. price level / U.K. price level
Nominal exchange rate = (100 + 5.5) / (100 + 4)
Nominal exchange rate = 1.0573

With the dollar depreciating against the pound by 3 percent, the new nominal exchange rate would be:

New nominal exchange rate = 1.0573 x (1 - 0.03)
New nominal exchange rate = 1.0246

Plugging in the numbers, we get:

Real exchange rate = (1.0246 x 100) / (100 + 4)
Real exchange rate = 98.49%

Converting to decimal form, we get:

Real exchange rate = 0.9849

Therefore, the best choice is B.

If the Annual Inflation Rate Is 5