Economics 236/336 Fall 2024 - 2025
American University of Beirut
Department of Economics
Economics 236/336
Week 3 Tutorial
Exchange Rates I: The Monetary Approach in the Long Run
NOTE: The tutorial problems are intended to provide applications and examples of economic
concepts and models introduced in the lectures. I will post the solutions to these tutorial questions
a week after. Please use this as a learning mechanism and not just a channel to get the solutions.
Please raise any issues or problems (after you have tried working on the problems) through the
online discussion forum on Moodle.
1. Suppose that two countries, Vietnam and Côte d’Ivoire, produce coffee. The currency unit used in Vietnam
is the dong (VND). Côte d’Ivoire is a member of the Communaut Financire Africaine (CFA), a currency
union of West African countries that use the CFA franc (XOF). In Vietnam, coffee sells for 4,500 dong
(VND) per pound. The exchange rate is 40 VND per 1 CFA franc, EV N D/XOF = 30.
(a) If the law of one price holds, what is the price of coffee in Côte d’Ivoire, measured in CFA francs?
(b) Assume the price of coffee in Cte dIvoire is actually 160 CFA francs per pound of coffee. Compute the
relative price of coffee in Côte d’Ivoire versus Vietnam. Where will coffee traders buy coffee? Where
will they sell coffee in this case? How will these transactions affect the price of coffee in Vietnam?
In Côte d’Ivoire?
2. Consider each of the following goods and services. For each, identify whether the law of one price will
hold, and state whether the relative price qU S/F oreign is greater than, less than, or equal to 1. Explain
your answer in terms of the assumptions we make when using the law of one price.
(a) Rice traded freely in the United States and Canada
(b) Sugar traded in the United States and Mexico; the U.S. government imposes a quota on sugar imports
into the United States
(c) The McDonalds Big Mac sold in the United States and Japan
(d) Haircuts in the United States and the United Kingdom
3. You are given the following information. The current dollarpound exchange rate is $1.5 per pound. A U.S.
basket that costs $100 would cost $120 in the United Kingdom. For the next year, the Fed is predicted to
keep U.S. inflation at 2% and the Bank of England is predicted to keep U.K. inflation at 3%. The speed
of convergence to absolute PPP is 15% per year.
(a) What is the expected U.S. minus U.K. inflation differential for the coming year?
(b) What is the current U.S. real exchange rate qU S/U K with the United Kingdom?
(c) How much is the dollar overvalued/undervalued?
(d) What do you predict the U.S. real exchange rate with the United Kingdom will be in one years time?
(e) What is the expected rate of real depreciation for the United States (versus the United Kingdom)?
(f) What is the expected rate of nominal depreciation for the United States (versus the United Kingdom)?
(g) What do you predict will be the dollar price of one pound a year from now?