Suppose, for example, that the Brazilian firm sells its shoes in the U. S. market for $10. Its profit margin is $6, or R300, because the shoes cost $4 to produce at the current exchange rate of R1 = $0.02. If Brazilian inflation is 100% but the nominal exchange rate remains constant, it will cost the manufacturer $8 to produce these same shoes by the end of the year. Assuming no U. S. inflation, how will the firm's profit be affected?

It's profit will decrease to 1/3 of current profits.

Explanation:

if the inflation in Brazil is high while the inflation rate in the US is low, the net profits of the firm will decrease:

before the firm could earn $6 from each pair of shoes sold in the US (= $10 - $4), but now it will only be able to earn $2 per pair of shoes (= $10 - $8). That means its profit will decrease to 1/3 of current profits.

The only way that this can be avoided is if the Brazilian real would depreciate against the US dollar by 100% which would offset the high inflation rate.

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