Question

If the nominal exchange rate (expressed as foreign currency per unit of the domestic currency) rises 5%, domestic inflation is 2%, and foreign inflation is 3%, what is the approximate percent change in the real exchange rate?

Answer 1

The approximate percent change in the real exchange rate is 6%, calculated by adjusting the 5% nominal exchange rate rise with the difference in inflation rates between home and foreign countries, which in this scenario is -1%.

Step-by-step explanation:

To calculate the approximate percent change in the real exchange rate, we need to consider both the nominal exchange rate changes and the inflation differentials between the two countries. The formula for the real exchange rate percentage change is given by:

Real Exchange Rate Change = Nominal Exchange Rate Change - (Domestic Inflation - Foreign Inflation)

In this case, the nominal exchange rate increases by 5%. The domestic inflation is 2%, and the foreign inflation is 3%. Using the formula, the approximate percent change in the real exchange rate would be:

5% (nominal change) - (2% domestic inflation - 3% foreign inflation) = 5% - (-1%) = 6%

The negative sign in front of the 1% indicates that the foreign inflation rate is higher than the domestic inflation rate, which impacts the real exchange rate positively in this scenario. Therefore, the real exchange rate has approximately increased by 6%.

Answer 2

3.333% which is approximately 3%.

Step-by-step explanation:

Real Exchange rate is the price of foreign goods compared to the price of domestic goods. This can be calculated using the following formula:

R = NER × (DPL ÷ FPL) ............................................... (1)

Where:

R = Real Exchange Rate

NER = Norminal Exchange Rate

DPL = Domestic Price Level

FPL = Foreign Price Level

When there is a change in the real exchange rate, equation (1) will expressed is follows:

ΔR = ΔNER × (ΔDPL ÷ ΔFPL) ............................................... (2)

Where:

ΔR = Change in Real Exchange Rate

ΔNER = Change in Norminal Exchange Rate = 5%

ΔDPL = Change in Domestic Price Level = Domestic Inflation = 2%

ΔFPL = Change in Foreign Price Level = Foreign Inflation = 3%

If we substitute all these values into equation (2), we can solve for ΔR as follows:

ΔR = 5% × (2% ÷ 3%)

= 5% × 0.6667

ΔR = 3.333%

Therefore, change in the real exchange rate is 3.333% which is approximately 3%.