Suppose the Real Exchange Rate X Between Canada and the U.S

Essay

Suppose the real exchange rate X between Canada and the U.S. is constant. Let the price level in Canada be P, the price level in the U.S. be P*, and the nominal exchange rate be
e. Suppose the price level in Canada increases from P1 to P2 and the price level in the U.S. increases from P1* to P2*. Show that the rate of change in e, which is equal to (e2 - e1)/e1 × 100 is approximately equal to the difference in the inflation rates in the two countries. Note that the nominal exchange rate is e = XP*/P. What have you learned from this exercise?