Question

At the beginning of the year, the exchange rate was 2.5 reals per dollar. Over the year, U.S. inflation was 7% and Brazilian inflation was 3%. If purchasing power parity holds, at year-end the exchange rate should be ________ reals per dollar.

a. 2.4
b. 2.6
c. 2.3
d. 2.7

Answer 1

Using the concept of purchasing power parity, adjusting for the U.S. inflation rate and then the Brazilian inflation rate, the end of year exchange rate should be 2.6 reals per dollar.

Step-by-step explanation:

If purchasing power parity (PPP) holds, the end of year exchange rate should adjust to reflect changes in inflation rates between the two countries. You start with an initial exchange rate of 2.5 reals per dollar. U.S. inflation of 7% would decrease the purchasing power of the dollar, indicating that you would need more reals to buy the same amount of goods. Brazilian inflation of 3% would similarly decrease the purchasing power of reals, but not as much as the dollar.

To calculate the new exchange rate:

1. Adjust the exchange rate for U.S. inflation: 2.5 reals/dollar × 1.07 (to account for U.S. inflation) = 2.675 reals/dollar.
2. Adjust for Brazilian inflation by dividing: 2.675 reals/dollar ÷ 1.03 (to account for Brazilian inflation) = 2.5971 reals/dollar.
3. Round to the nearest option provided, which is 2.6 reals per dollar (option b).

Therefore, the exchange rate at the end of the year, assuming PPP holds, should be 2.6 reals per dollar.