Real and nominal exchange rates and inflation
Using the definition of the real exchange rate, you can shows that
(∈t - ∈t-1)/∈t-1 = (Et - Et-1)/Et-1 + πt - π*t
In words, the percentage real appreciation equals the percentage nominal appreciation plus the difference between domestic and foreign inflation.
a. If domestic inflation is higher than foreign inflation, but the domestic country has a fixed exchange rate, what hap- pens to the real exchange rate over time? Assume that the Marshall-Lerner condition holds. What happens to the trade balance over time? Explain in words.
b. Suppose the real exchange rate is constant-say, at the level required for net exports (or the current account) to equal zero. In this case, if domestic inflation is higher than foreign inflation, what must happen over time to maintain a trade balance of zero?