If the annual inflation rate is 2.5 percent in the United States and 4 percent in the U.K.,and the dollar appreciated against the pound by 1.5 percent,then the real exchange rate,assuming that PPP initially held,is ________.

Question

Quizplus · Accepted Answer

The real exchange rate formula is:

Real Exchange Rate = Nominal Exchange Rate * (1 + Domestic Inflation) / (1 + Foreign Inflation)

Given: 
- Domestic inflation (U.S.) = 2.5%
- Foreign inflation (U.K.) = 4%
- Nominal exchange rate (dollars per pound) appreciated by 1.5%

Using the formula:

Real Exchange Rate = (Nominal Exchange Rate * (1 + Domestic Inflation)) / (1 + Foreign Inflation)

Real Exchange Rate = ((1 + 0.015) * 1) * (1 + 0.025) / (1 + 0.04) = 0.9710

Therefore, the real exchange rate is 0.9710, which means that the dollar has depreciated in real terms against the pound.

If the Annual Inflation Rate Is 2