Question

Assume that the nominal spot exchange rate (USD/EUR) increases by 7.5%, the eurozone price level decreases by 4%, and the US price level increases by 2.5%. The change in the real exchange rate (%) is closest to:a.0.7%.b.−6.3%.c.14.8%.

Answer 1

The change in the real exchange rate, after accounting for the changes in nominal exchange rate and the price level changes in both the eurozone and the US, is closest to 14%. Option c (14.8%) is therefore the nearest correct answer.

Step-by-step explanation:

The calculation of the change in the real exchange rate involves adjusting the nominal exchange rate for changes in price levels in both the domestic and foreign country. Therefore, we begin with a 7.5% increase in the nominal USD/EUR exchange rate. To find the real exchange rate change, we must also account for the inflation rates. Specifically, we deduct the eurozone's deflation of 4% and add the U.S.'s inflation of 2.5% from the change in the nominal rate. The calculation is as follows:

Nominal exchange rate change = 7.5%

Eurozone deflation = -4%

U.S. inflation = 2.5%

Change in real exchange rate = Nominal exchange rate change - Eurozone deflation + U.S. inflation

Change in real exchange rate = 7.5% - (-4%) + 2.5% = 7.5% + 4% + 2.5% = 14%

The change in the real exchange rate is closest to 14%, making option c (14.8%) the closest answer.

Answer 2

a. 0.7%

Step-by-step explanation:

The computation in the change in the real exchange rate is shown below:

Change in the real exchange rate = {(1 + change in nominal spot exchange rate) × (1 + change in the price level of euro-zone or foreign country)} ÷ (1 + change in the price level of US or domestic country) - 1

= {(1 + 7.5%) × (1 + -4%)} ÷ (1 + 2.5%) - 1

= {(1.075) × (0.96)} ÷ (1.025) - 1

= (1.032) ÷ (1.025) - 1

= 0.7%