Answer
a) 3 Wiknam pesos per Ectenia dollar
b) In Ectenia, the new price of Spam will be 4 dollars. In Wiknam, the new price of Spam will be 24 pesos. The exchange rate will increase to 6 Wiknam pesos per Ectenia dollar.
c) Wiknam will likely have the higher nominal interest rate due to the higher inflation rate.
d) Since the real interest rates (in terms of Spam) would be the same (i.e., in equilibrium), there would not be any benefit to borrowing from the country with the lower nominal interest rate and investing in the country with the higher interest rate.
Work Step by Step
a)
2 Ectenia dollars = 6 Wiknam pesos
2/2 Ectenia dollars = 6/2 Wiknam pesos
1 Ectenia dollar = 3 Wiknam pesos
b)
Inflation is 3.5% in Ectenia for the next 20 years
Inflation is 7% in Wiknam for the next 20 years
Ectenia
Using the rule of 70, we see that prices will take $70/3.5$, or 20 years to double. Since we are looking at the next 20 years, we find that prices will double in Ectenia once in 20 years.
In 20 years, the price of Spam will increase from 2 dollars to 4 dollars.
Wiknam
Using the rule of 70, we see that prices will take $70/7$, or 10 years to double. Since we are looking at the next 20 years, we find that prices will double in Wiknam $40/20$, or two times in 20 years.
In 20 years, the price of Spam will increase from 6 pesos to 24 pesos (since prices will have doubled due to inflation).
24 pesos = 4 Ectenia dollars
24/4 pesos = 4/4 Ectenia dollars
6 pesos per Ectenia dollar
