Economics 236/336 Fall 2024 - 2025

American University of Beirut

Department of Economics
Economics 236/336
Week 3 Tutorial - Solutions
Exchange Rates I: The Monetary Approach in the Long Run

1. Suppose that two countries, Vietnam and Cte dIvoire, 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?

According to LOOP, the price of coffee should be the same in both markets:
PVcof f ee 4500
PCcof f ee = = = 150XOF
EV N D/XOF 30

(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?

With an exchange rate of 30 VND per 1 CFA franc, the price of coffee in Vietnam measured in CFA
francs will be 150 as calculated in part (a). Traders will therefore buy coffee in Vietnam, because
buying coffee is cheaper there, and sell coffee in Cte dIvoire, because coffee sells for a higher price.
This will lead to an increase in the price of coffee in Vietnam and a decrease in the price 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

qU S/F oreign = 1. LOOP should hold in this case because its assumptions are met.

(b) Sugar traded in the United States and Mexico; the U.S. government imposes a quota on sugar im-
ports into the United States

qU S/F oreign < 1. If the U.S. government imposes a quota on sugar, this will lead to an increase in
the relative price of sugar in the United States through restricting competition.

(c) The McDonalds Big Mac sold in the United States and Japan

qU S/F oreign ∕= 1. The McDonalds Big Mac sold in the United States may sell for a different price
compared with Japan because there are nontradable elements in the production of the Big Mac, such
as labor and rent.

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Economics 236/336 Fall 2024 - 2025

(d) Haircuts in the United States and the United Kingdom

qU S/F oreign ∕= 1. Because haircuts cannot be traded across the United States and the United Kingdom,
consumers will not arbitrage away differences in the prices of haircuts in these two regions.

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?

The inflation differential is equal to −1% = +2% − 3%.

(b) What is the current U.S. real exchange rate qU S/U K with the United Kingdom?

The current real exchange rate is: qU S/U K = (E$/£ PU K )/PU S = $120/$100 = 1.2.

(c) How much is the dollar overvalued/undervalued?

The British pound is overvalued by 20% and the U.S. dollar is undervalued by 20%.

(d) What do you predict the U.S. real exchange rate with the United Kingdom will be in one years time?

We can use the information on convergence to compute the implied change in the U.S. real exchange
rate. We know the speed of convergence to absolute PPP is 15%; that is, each year the exchange rate
will adjust by 15% of what is needed to achieve the real exchange rate equal to 1 (assuming prices
in each country remain unchanged). Today, the real exchange rate is equal to 1.2, implying that the
current price of the basket in pounds, PU K = 80£, and a 0.2 decrease is needed to satisfy absolute
PPP (qU S/U K = 1). Over the next year, 15% of this adjustment will occur, so the real exchange rate
will decrease by 0.03. Therefore, after one year, the U.S. real exchange rate qU S/U K will equal 1.17.

(e) What is the expected rate of real depreciation for the United States (versus the United Kingdom)?

From part (d), the real exchange rate will decrease by 0.03. Therefore, the rate of real depreciation
is approximately equal to -2.5% = -0.03/1.2. This implies a real appreciation in the United States
relative to the United Kingdom.

(f) What is the expected rate of nominal depreciation for the United States (versus the United Kingdom)?

The expected rate of nominal depreciation can be calculated based on the inflation differential plus the
expected real depreciation from part (e). In this case, the inflation differential is 1% and the expected
real appreciation is 2.5%, so the expected nominal depreciation is 3.5%; that is, we expect a 3.5%
appreciation in the U.S. dollar relative to the British pound.

(g) What do you predict will be the dollar price of one pound a year from now?

The current nominal exchange rate is $1.5 per pound, and we expect a 3.5% appreciation in the
dollar (from [f ]). Therefore, the expected exchange rate in one year is approximately equal to $1.45 =
$1.5 × (1 − 0.035).