Assume that relative purchasing-power parity holds. In 2004, the price level in Japan is 120 and the price level in the U.S. is 145. In 2005, the price level in Japan is 121 and the price level in the U.S. is 149. The exchange rate in 2004 is 112 yen per dollar. Calculate the exchange rate in 2005.
What will be an ideal response?
Because relative purchasing-power parity holds, we can use the equation %?X = ?F??, where the exchange rate is in yen per dollar, so Japan is the foreign country and the U.S. is the domestic country. The inflation rate in Japan is 100% × (121 ? 120)/120 = 0.83%. The inflation rate in the U.S. is 100% × (149 ? 145)/145 = 2.76%. Because %?X = ?F??, then, %?X = 0.83% ? 2.76% = ?1.93%. Because %?X = 100% × (X2005?X2004) / X2004 = 100% × (X2005? 112) / 112 = ?1.93%, then X2005 = [(?1.93%/100%) × 112] + 112 = 109.84.
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