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nAnswers to Textbook Problems
1. Relative PPP predicts that inflation differentials are matched by changes in the exchange rate.
2. A real currency appreciation may result from an increase in the demand for nontraded goods
relative to tradables which would cause an appreciation of the exchange rate since the increase in
the demand for nontradables raises their price, raising the domestic price level and causing the
currency to appreciate. In this case, exporters are indeed hurt, as one can see by adapting the analysis
3. a. A tilt of spending toward nontraded products causes the real exchange rate to appreciate as the
b. A shift in foreign demand toward domestic exports causes an excess demand for the domestic
4. Relative PPP implies that the pound/dollar exchange rate should be adjusted to offset the inflation
5. The real effective exchange rate series for Britain shows an appreciation of the pound from 1977 to
1981, followed by a period of depreciation. Note that the appreciation is sharpest after the increase
in oil prices starts in early 1979; the subsequent depreciation is steepest after oil prices soften in 1982.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
Chapter 16 Price Levels and the Exchange Rate in the Long Run 83
6. A permanent shift in the real money demand function will alter the long-run equilibrium nominal
exchange rate, but not the long-run equilibrium real exchange rate. Since the real exchange rate
does not change, we can use the monetary approach equation, E (M/M*) {L(R*, Y*)/L(R, Y)}.
7. The mechanism would work through expenditure effects with a permanent transfer from Poland
to the Czech Republic appreciating the koruna (Czech currency) in real terms against the zloty
8. As discussed in the answer to Question 7, the koruna appreciates against the zloty in real terms
with the transfer from Poland to the Czech Republic if the Czechs spend a higher proportion of
9. Since the tariff shifts demand away from foreign exports and toward domestic goods, there is a
10. The balanced expansion in domestic spending will increase the amount of imports consumed in the
11. A permanent increase in the expected rate of real depreciation of the dollar against the euro leads to a
permanent increase in the expected rate of depreciation of the nominal dollar/euro exchange rate,
12. Suppose there is a temporary fall in the real exchange rate in an economy, that is, the exchange
rate appreciates today and then will depreciate back to its original level in the future. The expected
depreciation of the real exchange rate, by real interest parity, causes the real interest rate to rise. If
13. International differences in expected real interest rates reflect expected changes in real exchange
rates. If the expected real interest rate in the United States is 9 percent and the expected real interest
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
Chapter 16 Price Levels and the Exchange Rate in the Long Run 84
14. The initial effect of a reduction in the money supply in a model with sticky prices is an increase
in the nominal interest rate and an appreciation of the nominal exchange rate. The real interest rate,
which equals the nominal interest rate minus expected inflation, rises by more than the nominal
interest rate since the reduction in the money supply causes the nominal interest rate to rise, and
15. One answer to this question involves the comparison of a sticky-price with a flexible-price model.
In a model with sticky prices, a reduction in the money supply causes the nominal interest rate to
rise and, by the interest parity relationship, the nominal exchange rate to appreciate. The real interest
rate, which equals the nominal interest rate minus expected inflation, increases both because of the
increase in the nominal interest rate and because there is expected deflation. In a model with perfectly
16. If long-term rates are higher than short-term rates, it suggests that investors expect interest rates to be
higher in the future, that is why they demand a higher rate of return on a longer bond. If they expect
interest rates to be higher in the future, they are either predicting higher inflation in the future or a
higher real interest rate. We cannot tell which by simply looking at short and long rates. 17. If we
18. If markets are fairly segmented, then temporary moves in exchange rates may lead to wide deviations
from PPP even for tradable goods. In the short run, firms may not be able to respond
by opening up new trading relationships or distribution channels. On the other hand, if there are
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
Chapter 16 Price Levels and the Exchange Rate in the Long Run 85
19. PPP for nontradables would arise if technologies were similar across countries, and thus similar
prices for goods in the long run would be consistent with competitive markets and similar labor costs.
If the labor costs are similar, then (again assuming similar technologies) the costs of non-tradables
should be similar also. Of course, as the chapter notes, differences in productivity that
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
