CFA Practice Question

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CFA Practice Question

Assume the nominal exchange rate (CA$/US$) increases by 10%, the inflation rate in Canada is 2%, and the inflation rate in the U.S. is 5%. The change in the real exchange rate is then ______.
A. 3%
B. 7%
C. 13%
Explanation: (1 + 10%) x (1+5%)/(1 + 2%) - 1 = 13%

User Contributed Comments 6

User Comment
andyphung Could someone please explain to me this question?
If nominal rate CA$/US$ increases by 10% it means that CA$ depreciates against US$ by 10%. On the other hand, inflation rate is expected to be 2% in CA and 5% in US. This means that CA$ would appreciate by 3% (5-2) against US$. Combining those issues, this nominal rate CA$/US$ should increase by 7% (decrease 10% and increase 3%)
mstroh314 Suppose CA$/US$ is flat, the inflation rate in Canada is 0, and the inflation rate in the US is 5%. Thus, a Canadian individual lost 5% purchasing power for US goods --> the real exchange rate CA$/US$ has increased by 5%.

Suppose nominal CA$/US$ +5%, the inflation rate in both countries is 0. Again a Canadian lost 5% purchasing power for US goods --> the real exchange rate CA$/US$ has increased by 5%.
something It's always the currency in the denominator that depreciates or appreciates with respect to numerator currency. In this case, US dollar was in denominator, i.e. now instead of x CA dollars, you need 1.1x CA to buy same US dollar. Therefore US dollar appreciated by 10% on a normal basis. Now the numerator currency is actually 1.1x/(1.02) because CA dollar had 2% inflation, so what you are getting is little less than 1.1. Likewise, US dollar also had inflation of 5% and that means in real basis you need (1.1x/1.02)*1.05 of CA dollars, to compensate for US inflation. This whole calculation is from denominator currency perspective.
MarcCFA Guide to solving these questions:
1. What does CA / USD increased by 10% mean? -> USD (base currency) got 10% stronger / appreciated.
2. Find inflation differential -> 3% difference with higher inflation in USD.
3. Therefore USD should have depreciated by 3%, in order for parity conditions to hold or easier, in order for canadians to be able to buy US goods at old prices. It's not their fault that the inflation in the US is higher right. Why should they pay more now?
4. Now that we established that USD gained 10%, but should have lost 3%, we add 3% to the 10% and end up with a real increase of 13%.

Conclusion:
Canadian buyers are now really screwed because they have to pay more due to increased exchange rate (10%) and more due to higher US inflation (3%)
Similarly US exporters are screwed as Canadian demand for US goods will drop.
SalimBouch exchange rate (CAD/USD), means the domestic currency is USD, right? because comparing the formula we have in the los associated and the result here means USD is the foreign currency. so I am confused :(
renataa MarkCFA, good explanation! thanks
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