# Why aren't they using the regular real exchange rate formula?

Can someon explain why they aren’t just solving for the nominal exchange rate in the regular formula of: Real exchange rate = nominal x (1+foreign/1+domestic)

Assume the percentage increases in each of the following listed items:

Percentage increase

Real domestic exchange rate (USD/EUR)

5

Eurozone price level

2

U.S. price level

1.5

The predicted change in the nominal US spot exchange rate is closest to:

5.5%. 4.5%. –0.5%.

Incorrect.  they use the no-arbitrage exchange rate formula:

forward (dom/for) / spot (d/f) = (1+ int dom) / (1+int for.)

then they moved spot to the right side of the equation and replaced it with (1+ int dom) / (1+int for.)

Which gives you: forward (dom/for) / ((1+ int dom) / (1+int for.)) = spot (d/f)

a / (b/c) = a x (c/b)

You end up with: forward (dom/for) x ((1+int for.) / (1+ int dom) = spot (d/f)

Plug in the values (percentage changes):

(1.05) x (1.015/1.02) -1 = spot ------ spot = 1.04485 - 1 = +4.5%

Hi,

I think the answer is incorrect. This is not regarding Interest rate parity but a question regarding CPI.

In this case the change in foreign CPI should be in the numerator.

I believe the answer given is wrong. I am happy to be corrected though.

Regards

They’re looking for the percentage change (i.e., (new rate − old rate) / old rate), not the incremental change (i.e., new rate − old rate).

Well , None of us read the question properly (Me included) , The question gives real exchange and asks us to calculate the nominal exchange rate , so the formula Real exchange rate = nominal x (1+foreign/1+domestic) needs to be rearranged. That’s why domestic CPI appears in the numerator.

Well it took me , 30 minutes but the importance of reading the question properly cannot stressed enough.

4 letters to live by : RTFQ (Read The F***ing Question)