Sum

Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and the price level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of Japanese goods in terms of Indian goods).

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#### Solution

Price level in foreign country: (Japan) P_{f} = 3

Price level in home country: (India) P = 1.2

Now, real exchange rate `= e(P_f)/P`

Price of 1.25 yen = 1 rupee

Price of 1 yen` =1/25=100/125 = 4/5`

Therefore, `e = 4/5`

So, real exchange rate `=e(P_f)/P`

`=4/5xx30/1.2`

= 2

Therefore, the real exchange rate is 2.

#### Notes

First find out the nominal exchange rate as a price of yen in rupees.

Concept: Foreign Exchange Market - Determination of the Exchange Rate

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