Discussion:
1. The current exchange rate between the Japanese yen and the U.S. dollar is 80 yen per dollar. At current prices, a basket of goods that costs $100 to produce in the U.S.
would cost ¥7,200 to produce in Japan. Over the coming year, the inflation rate in Japan is expected to be -1%, while the inflation rate in the U.S. is predicted to be 3%. The speed of convergence in the real exchange rate to PPP is 50% per year.
a. What is the current real exchange rate between the two countries, expressed as the price of U.S. goods relative to (divided by) the price of Japanese goods?
b. Is the dollar overvalued or undervalued against the yen?
c. What do you predict the real exchange rate will be one year from now?
d. What do you predict the yen per dollar nominal exchange rate will be in one year?
2. Richland and Poorland each have two industries: traded food and nontraded house maintenance. It takes 1 day for a worker in each country to maintain a house.
It takes 1 day for a Richland worker to produce a unit of food and 3 days for a Poorland worker to produce a unit of food. The wage rate in Richland is $100 per day, and the wage rate in Poorland is Ps200.
a. What is the equilibrium exchange rate (measured as pesos per dollar)?
b. What is the dollar price of food in Richland? In Poorland?
c. What is the dollar price of house maintenance in Richland? In Poorland?
d. Suppose that productivity in Poorland's food industry improves, so that it now only takes 2 days of labor to produce a unit of food. If the government of Poorland wishes to keep the peso per dollar exchange rate fixed at the level you calculated for part (a), what must happen to the peso wage and the peso prices of food and house maintenance in Poorland? Assume there are no changes in Richland's economy.
3. Over the next twenty years, the average overall rate of inflation in Mexico is expected to be 12% per year, while in the United States the general rate of inflation is expected to average 4% percent per year. Because of continued foreign direct investment in Mexico, productivity gains in Mexico manufacturing are expected to hold the inflation rate in sectors that produce tradable goods to 8%, with the rest of the economy averaging 16% inflation. In the United States, inflation is expected to be more uniform throughout the economy. These figures are summarized in the table below.
Inflation in Inflation in Average
Prices of Prices of Overall
Traded Goods Nontraded Goods Inflation
Mexico 8% 16% 12%
United States 4% 4% 4%
a. Based on the information above, we can expect that over the next twenty years, the average annual percentage change in the peso per dollar exchange rate will be ______.
b. Real exchange rates are used to identify the portion of a change in a nominal exchange rate that cannot be accounted for by a difference in the countries' overall rates of inflation. Suppose that the real exchange rate in this problem is measured as the relative price of all U.S. goods (traded and nontraded) to, or divided by, the price of all Mexican goods (traded and nontraded). Then the
average annual percentage change in the real exchange rate will be ______.