Consider the bilateral exchange rate between Australia and New Zealand. Suppose $1 AUD buys $1.05 NZD, the Australian price level is $100 AUD and the New Zealand price level is $110 NZD. Which of the following is TRUE?Group of answer choicesThe Australian dollar has more real purchasing power than the New Zealand dollarIn the long run, the New Zealand dollar is likely to depreciate against the Australian dollarThe real exchange rate is 0.90The real exchange rate is 1.10
Question
Consider the bilateral exchange rate between Australia and New Zealand. Suppose 1.05 NZD, the Australian price level is 110 NZD. Which of the following is TRUE?Group of answer choicesThe Australian dollar has more real purchasing power than the New Zealand dollarIn the long run, the New Zealand dollar is likely to depreciate against the Australian dollarThe real exchange rate is 0.90The real exchange rate is 1.10
Solution
The real exchange rate is calculated by adjusting the nominal exchange rate for price level differences between countries. In this case, the nominal exchange rate is 1.05 NZD.
The formula for the real exchange rate is (e x P*)/P, where e is the nominal exchange rate, P* is the foreign price level, and P is the domestic price level.
Substituting the given values into the formula, we get:
Real exchange rate = (1.05 x 110) / 100 = 1.155
Therefore, none of the provided options for the real exchange rate are correct.
As for the purchasing power, it is determined by the amount of goods and services that can be bought with a unit of currency. In this case, 1 NZD can buy in Australia, because 1.05 NZD and the price level in New Zealand is higher. Therefore, the Australian dollar has more real purchasing power than the New Zealand dollar.
As for the future depreciation or appreciation of the New Zealand dollar, it's not possible to determine from the given information. Changes in exchange rates in the long run are influenced by a variety of factors, including inflation rates, interest rates, public debt, terms of trade, political stability and economic performance.
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