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

Answer:

3.333% which is approximately 3%.

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%.