UC3M

International Economics
Problem Set 8

Exchange Rates and Purchasing Power Parity

1. i) Explain the difference between nominal exchange rate and real exchange rate. ii)
What happens to the balance of trade if the real exchange rate increases? (explain).
iiI) What does the empirical evidence for Spain says about the relationship between
trade balance and the effective real exchange rate?

2. i) How could a depreciation of the real exchange rate help an economy (hint: use the
correlation aggregate demand and the real exchange rate) iii) If the real exchange rate is
smaller than one then capital inflows are smaller than capital outflows. Is this statement
try or false? (in order to make life more easy, assume they net income from abroad (NIA)
is equal to zero)

3. i) What does Purchasing Power Parity PPP (means) ii) When does PPP holds? (relate
your explanation to the real exchange rate (RER). iii) If PPP holds, what should happen
to the nominal exchange rate of a country with high inflation? (relative to the inflation
of the mayor trading countries?) iv) Explain the difficulties of the Chinese government
to keep the RER below one.

4. i) Why does PPP does not hold any longer for Spain? Why is the Spanish real exchange
fixed close to a value higher than one? (and below one for Germany) Are these good or
bad news for Germany?

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5. i) Using the price of a Big Mac as a reference, calculate the actual real exchange rate
between Spain and USA (using Spain as the domestic country). ii) Using your result
to the previous, which should the exchange rate between the dollar and the euro in the
long run?

6. Trump Dreams makes 10,000 dollars in profit in the USA, while the branch in Spain (Los
Sueños de Sanchez) makes 8, 000 euros. Which branch makes more profit? (Compare
profits using two methods: the market nominal exchange rate and the nominal exchange
rate such that PPP holds. In order to find this exchange rate you can use the Big Mac
Index from the previous question). If a branch has to disappear, which once should be
closed?