Question

In January 2012, one US dollar was worth 50 Indian rupees. Suppose that over the next year the value of the Indian rupee decreases to 60 Indian rupees to one US dollar. Suppose also that the price level of all goods and services in India, as measured in rupees, falls 20%, so that the Indian price index falls from a value of 100 to 80. At the same time, suppose that the US price level increases by 6%, to 106.

By what percentage did the value of the real exchange rate change over this period? Please give your answer to the nearest whole percentage point.
What will happen to the following as a result of the changes?
America's consumption of Indian goods and services will likely...
a)increase
b)decrease
c)stay the same
India's consumption of American goods and services will likely...
a)increase
b)decrease
c)stay the same

Answer 1

The value of the real exchange rate changed by 59% over the specified period. Consequently, American consumption of Indian goods and services will likely increase, while India's consumption of American goods and services will likely decrease.

Step-by-step explanation:

To calculate the percentage change in the real exchange rate, we have to adjust the nominal exchange rate change by the inflation rates of the two countries. From January 2012 to January 2013, the Indian rupee has depreciated from 50 INR/USD to 60 INR/USD, which is a 20% nominal depreciation (60-50)/50*100. However, taking into account inflation, with a 20% decrease in Indian prices (from 100 to 80) and a 6% increase in US prices (from 100 to 106), we can calculate the real exchange rate change.

The real exchange rate (RER) can be computed as follows: (Nominal Exchange Rate * Price Level abroad) / Price Level home. The initial RER is (50 INR/USD * 100) / 100 = 50. The final RER is (60 INR/USD * 106) / 80 = 79.5. Thus, the real exchange rate has changed by (79.5 – 50) / 50 * 100 = 59% to the nearest whole percentage point.

With a weaker rupee and lower price level in India, American consumption of Indian goods and services will likely increase, as these goods become cheaper for Americans. Conversely, with a stronger dollar and a higher price level in the US, India’s consumption of American goods and services will likely decrease, since these goods become more expensive for Indians.