Question: At a base period, the CPIs of the U.S. and U.K. are both 100, and the exchange rate is $1.70/GBP. 3 years later, the exchange rate is $1.60/GBP, and the CPI has risen to 110 in US and 112 in UK. What is the real exchange rate?
I did this using two methods, but I got different answers with each one:
Method 1:
$new = $old * 110
£new = £old * 112
Now, $1.6/GBP after three years means 1 £new = 1 $new * 1.6
Let’s substitute old values to get the real exchange rate: 1 * (£old * 112) = 1* ($old * 110) * 1.6
Therefore, 1 £old = (1.6*110/112) * 1 $old => $1.5714/£, which is incorrect.
[I do believe the problem lies in $new = $old \* 110 and £new = £old \* 112. However, I wrote that equation because if I had bought a candy worth $1 three years ago, it would be $1.12 now. I really cannot decipher this.]
Method 2:
GBP has depreciated by : 5.88%; Inflation in GBP has increased by 1.81% relative to USD. Therefore, depreciation of GBP in real terms =~ 5.88% - 1.81% = 4.072%
A million dollar question for me is: What’s wrong with my Method 1? I spent two hours trying to figure out what is it that I am missing. However, I have no clue. I’d appreciate any help.