Question

Suppose the euro-dollar exchange rate moves from S0.90 per euro to S0.92 per euro. At the same time, the prices of European-made goods and services rise 1 percent, while prices of American-made goods and services rise 3 percent. What has happened to the real exchange rate between the dollar and the euro?

The real dollar/euro exchange rate has (not changed significantly or increased or decreased).
Assuming the same change in the nominal exchange rate, what if inflation were 3 percent in Europe and 1 percent in the United States?
The real dollar/euro exchange rate will (not change significantly or increase or decrease).

Answer 1

The real exchange rate will decrease when the nominal exchange rate rises from $0.90 to $0.92 per euro, and European goods experience lower inflation than American goods. If inflation is higher in Europe and lower in the U.S. with the same nominal rate change, the real exchange rate remains relatively unchanged.

Step-by-step explanation:

When the exchange rate moves from $0.90 per euro to $0.92 per euro, and European inflation is at 1%, while U.S. inflation is at 3%, there is both a nominal change in the exchange rate and a change in the price level between the two economies. The real exchange rate accounts for both these changes and is calculated by adjusting the nominal exchange rate by the price levels (inflation rates). The real exchange rate will decrease, meaning that U.S. goods become relatively cheaper than European goods when both the exchange rate changes and price levels are considered.

However, if the scenario changes and the inflation is 3% in Europe and 1% in the United States, with the same change in the nominal exchange rate, the real exchange rate would not change significantly. This is because the nominal exchange rate change would be offset by the relative difference in inflation rates between the two economies. As inflation increases the price of goods and services, a higher inflation rate in Europe compared to the United States would tend to make European products more expensive relative to American goods, countering the effects of a weakening dollar.