Question

Assume that the home country trades with exactly two foreign countries; 75% of its trade volume is with country A, and 25% of its trade volume is with country B. If the home country's exchange rate with country A depreciates by 16% and the exchange rate with country B appreciates by 8%, what happens to the home country's effective multilateral exchange rate? a. It depreciates by 8%. b. It appreciates by 8%. c. It depreciates by 10%. d. It appreciates by 10%.

Answer 1

To determine the impact on the home country's effective multilateral exchange rate, we need to consider the weights of the trade volume with each country and the respective exchange rate changes.

Given that 75% of the trade volume is with country A and its exchange rate depreciates by 16%, while 25% of the trade volume is with country B and its exchange rate appreciates by 8%, we can calculate the effective multilateral exchange rate change as follows:

Effective multilateral exchange rate change = (Weighted exchange rate change with A) + (Weighted exchange rate change with B)

= (0.75 * -16%) + (0.25 * 8%)

= -12% + 2%

= -10%

Therefore, the home country's effective multilateral exchange rate depreciates by 10% (option c).