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Question
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) Pf = 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.
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