The solid line in the chart above shows movements since 1995 in the real exchang
ID: 1189839 • Letter: T
Question
The solid line in the chart above shows movements since 1995 in the real exchange rate between the Mexican peso and the Chinese renminbi (RMB). The dashed line is the simple mean of that series from 1995-2014 and is equal to .630. Assume that the mean represents the long-run equilibrium value for the real exchange rate and that the real exchange rate will slowly revert to that mean over time. Specifically, assume that the speed of convergence in the real exchange rate to its long-run equilibrium value is 20% per year. In other words, when forecasting what the real exchange rate will be in 2015, take the gap between the real exchange rate in 2014 and its long-run mean of .630 and assume that this gap will only narrow by 20% in one year.
The table below shows information for 2014 on the nominal exchange rate between the peso and the renminbi (expressed as pesos per RMB) and the GDP deflators (overall price indexes) for the two countries. Use this information to answer the questions below. In answering part (b) of the question, assume that the rate of inflation over the next year will be 5% in Mexico and 2% in China. Show all work.
Year pesos per Mexico GDP deflator China GDP deflator
RMB (2005=100) (2005=100)
2014 2.16 147.4 147.5
a. What was the value for the real exchange in 2014, expressed as the price of Mexican goods relative to (or divided by) the price of Chinese goods?
b. Using the inflation forecasts given above and the assumed speed of convergence in the real exchange, prepare a forecast of the nominal exchange rate (expressed as pesos per RMB) for 2015.
Explanation / Answer
Ans a) Real Exchange Rate = (Nominal Exchange Rate* Price level of foreign country) / Price level of domestic country
From above table , Real Exchange Rate = (2.16 * 147.5)/147.4 = 2.1615
Ans b) As the real exchange rate is above its long run equilibrium therefore its must fall in 2015 in order to converge to its long run value. Therefore, in 2015
Real Exchange Rate = 2.1615 -2.1615*(.20) = 2.1615 – 0.4323 = 1.7292
Mexican GDP deflator = 147.4 + 147.4*(0.05) = 147.4 + 7.37 = 154.77
Chinese GDP deflator = 147.5 + 147.5*(0.02) = 147.5 + 2.95 = 150.45
Nominal Exchange Rate = (Real Exchange Rate* Price level of domestic country) / Price level of foreign country
Nominal Exchange Rate = (1.7292 * 154.77) / 150.45 = 1.77 in 2015