Dollar. at Current Prices, a Basket of Goods That Costs $100 to Produce in the U.S

ECN 438 Homework 3 Due 3/20

Spring 2013

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 takes1 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 Richlandis $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?

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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,

theaverage 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 realexchange 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 realexchange rate will be______.