Translation of Nominal to Real Exchange Rate Changes in a FlexIT Economy

Country X and Country Y both have independent central banks that use monetary policy to target an inflation rate of 2% annually, and both allow their currencies to be traded freely on the foreign exchange market. Over the past five years, both central banks have been successful in keeping inflation very close to their 2% target. Given this information, which of the following statements best analyzes the expected behavior of the ratio of Country Y's price level to Country X's price level (P_Y / P_X) over this period?

Evaluating Price Level Stability

Explaining Price Ratio Stability

Evaluating the Limits of Price Ratio Stability

If Country A and Country B both successfully maintain an inflation target of 3%, it is guaranteed that the ratio of their price levels (P_B / P_A) will remain stable, regardless of their exchange rate policies.

Match each economic scenario involving a domestic and a foreign country with the most likely outcome for the ratio of their price levels (Foreign Price Level / Domestic Price Level).

When two countries both operate with flexible exchange rates and successfully target similar, low rates of price level growth, the ratio of their respective price levels tends to remain relatively ________.

A domestic and a foreign country both adopt a specific set of macroeconomic policies. Arrange the following statements into a logical sequence that explains how these policies lead to a particular outcome for the ratio of their price levels.

Predicting the Impact of a Policy Shift on Price Ratios

For several years, two countries, Richland and Poorland, both allowed their currencies to float freely and successfully used monetary policy to maintain an annual inflation rate of approximately 2%. During this period, the ratio of Poorland's price level to Richland's price level (P_Poorland / P_Richland) was observed to be very stable.

Suppose a major political shift in Poorland leads its central bank to abandon its previous policy, resulting in an average annual inflation rate of 10% over the next three years. During this same time, Richland's central bank continues to successfully maintain its 2% inflation target.

Which of the following outcomes is the most likely consequence of this policy divergence for the price ratio (P_Poorland / P_Richland)?