Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and the price level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of Japanese goods in terms of Indian goods). (Hint: First find out the nominal exchange rate as a price of yen in rupees).
Step 1: Calculate the Nominal Exchange Rate (Price of Yen in Rupees)
Given: 1.25 yen = 1 rupee
To find the price of yen in rupees, we take the reciprocal: Nominal Exchange Rate (e) = 1 ÷ 1.25 = 0.8 rupees per yen
This means 1 yen costs Rs 0.8.
Step 2: Calculate the Real Exchange Rate
The Real Exchange Rate is calculated using the formula:
Real Exchange Rate = (Nominal Exchange Rate × Price Level in Foreign Country) / Price Level in Domestic Country
Given:
- Nominal Exchange Rate (e) = 0.8
- Price Level in Japan (Pf) = 3
- Price Level in India (Pd) = 1.2
Real Exchange Rate = () / 1.2
= 2.4 / 1.2
= 2
Answer: The real exchange rate between India and Japan is 2. This means that Japanese goods are twice as expensive as Indian goods when compared in terms of the same currency.
Explanation
This question tests the concept of real exchange rate calculation. The hint guides students to first convert the given exchange rate (yen per rupee) into the standard format (rupees per yen). The real exchange rate formula compares the relative price levels between two countries adjusted for the nominal exchange rate. A real exchange rate of 2 indicates that Japanese goods cost twice as much as Indian goods, reflecting the higher price level in Japan.
Solution Steps
Step 1: Convert the given rate '1.25 yen per rupee' to find the price of yen in rupees: e = 1/1.25 = 0.8 rupees per yen
Step 2: Apply the real exchange rate formula: Real Exchange Rate = (e × Price Level in Japan) / Price Level in India
Step 3: Substitute values: Real Exchange Rate = () / 1.2 = 2.4 / 1.2 = 2