The Open Economy
45
e.
The increase in the world interest rate reduces domestic investment, which
increases the supply of dollars that are available to invest abroad. The domestic
currency becomes less valuable, and domestic goods become less expensive rela-
tive to foreign goods. The real exchange rate falls, as is shown in Figure 6-18.
10.
The easiest way to tell if your friend is right or wrong is to consider an example.
Suppose that ten years ago, an American hot dog cost $1, while a Mexican taco cost 10
pesos. Since $1 bought 10 pesos ten years ago, it cost the same amount of money to buy
a hot dog as to buy a taco. Since total U.S. inflation has been 25 percent, the American
hot dog now costs $1.25. Total Mexican inflation has been 100 percent, so the Mexican
taco now costs 20 pesos. This year, $1 buys 15 pesos, so that the taco costs 20 pesos [15
pesos
/
dollar] = $1.33. This means that it is now more expensive to purchase a Mexican
taco than a U.S. hot dog.
Thus, your friend is simply wrong to conclude that it is cheaper to travel in
Mexico. Even though the dollar buys more pesos than it used to, the relatively rapid
inflation in Mexico means that pesos buy fewer goods than they used to—it is more
expensive now for an American to travel there.
S
r
Real interest rate
I, S
Investment, Saving
r
2
*
I
(
r
)
r
1
*
Trade
surplus
Figure 6-17
∋
∋
∋
Real exchange rate
A
B
NX
NX
(
)
Net exports
1
∋
2
NX
2
(
S
–
I
)
1
(
S
–
I
)
2
NX
1
Figure 6-18

11.
a.
The Fisher equation says that
i
=
r +
π
e
where
i
= the nominal interest rate
r
= the real interest rate (same in both countries)
π
e
= the expected inflation rate.
Plugging in the values given in the question for the nominal interest rates for
each country, we find:
12 =
r
+
π
e
Can
8 =
r
+
π
e
US
This implies that
π
e
Can
–
π
e
US
= 4.
Because we know that the real interest rate
r
is the same in both countries, we
conclude that expected inflation in Canada is four percentage points higher than
in the United States.
b.
As in the text, we can express the nominal exchange rate as
e
=
ε ×
(
P
Can
/
P
US
),
where
ε
= the real exchange rate
P
Can
= the price level in Canada
P
US
= the price level in the United States.
The change in the nominal exchange rate can be written as:
% change in
e
= % change in
ε
+ (
π
Can
–
π
US
).
We know that if purchasing-power parity holds, then a dollar must have the same
purchasing power in every country. This implies that the percent change in the
real exchange rate
ε
is zero because purchasing-power parity implies that the real
exchange rate is fixed. Thus, changes in the nominal exchange rate result from
differences in the inflation rates in the United States and Canada. In equation
form this says
% change in
e
= (
π
Can
–
π
US
).
Because people know that purchasing-power parity holds, they expect this rela-
tionship to hold. In other words, the expected change in the nominal exchange
rate equals the expected inflation rate in Canada minus the expected inflation
rate in the United States. That is,
Expected % change in
e
=
π
e
Can
–
π
e
US
In part (a), we found that the difference in expected inflation rates is 4 percent.