Final answer:
Purchasing power parity predicts that when the real exchange rate is out of balance, adjustments will occur either through currency appreciation/depreciation or through changes in price levels. In this scenario with a real exchange rate of 0.7, the U.S. dollar could depreciate or the Japanese price level could rise to restore balance according to PPP principles. Option number a and e is correct.
Step-by-step explanation:
When considering the real exchange rate between the dollar and the yen being 0.7 (Japanese goods per U.S good), purchasing power parity (PPP) predicts outcomes related to the exchange rate and price levels. According to PPP, when a country's currency buys fewer goods abroad than it does domestically, that currency is likely to depreciate, and vice versa. If this real exchange rate is out of balance, it may adjust through changes in the nominal exchange rate or in the price level of one or both countries.
Therefore, if the real exchange rate between the dollar and the yen is 0.7, it suggests that U.S. goods are relatively more expensive than Japanese goods. For PPP to hold in the long-term, either:
The U.S. dollar will depreciate, making U.S. goods cheaper for foreigners and restoring the balance (Possible Answer A).
Alternatively, the Japanese price level will rise, making Japanese goods more expensive and reducing their competitiveness with U.S. goods (Possible Answer E).
The options B, C, D, and F are not directly predicted by PPP based on the given real exchange rate of 0.7. However, B and D could be eventual outcomes if market forces led to an appreciation of the U.S. dollar or a fall in the U.S. price level, either of which would alter the real exchange rate balance. The same goes for C and F regarding eventual changes in price levels in reaction to market forces aiming to restore PPP.