Question

Suppose that initially the nominal exchange rate was 40 rupees per dollar but it is now 50 rupees per dollar. If the nominal exchange rate is 50 rupees per dollar and the inflation rate in India is 25%, while the aggregate price level has remained unchanged in the United States, the real exchange rate between the U.S. dollar and the Indian rupee:
A) remains unchanged at 40.

B) remains unchanged at 50.

C) increases from 40 to 50.

D) increases by more than 25%.

Answer 1

Answer:

A) remains unchanged at 40.

Explanation:

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real exchange rate = (Nominal exchange rate x Price of the foreign basket) / (Price of the domestic basket)

the price of the US basket did not change over the couse of the year while the basket of indian goods increased by 25%

We plug this into the formula and obtain:

real exchange rate = 50 x 1/1.25 = 40