The real exchange rate approach to exchange rate determination is based on: q$/€

Question

The real exchange rate approach to exchange rate determination is based on: q$/€ = R$/€ × PEU PUS or R$/€ = q$/€ × PUS PEU a) Given PUS = 115, PEU = 105, and R$/€ = $1.35 per euro, compute the real exchange rate. ( 5 pts) b) Explain what the computed real exchange rate means. (5 pts) c) From the above-mentioned real exchange approach, write an equation to show a formula for the percent change in the nominal exchange rate. (5 pts) d) Using the formula that you write in (c), predict the percent change in the nominal exchange rate R$/€ in a year if the annual percent changes for PUS, PEU , and q$/€ are 5%, 10%, and 1%, respectively. (5 pts) e) From results of (d), explain whether home currency ($) appreciates against foreign currency (€) in both nominal and real terms. (10 pts)

Explanation / Answer

(a)

Real exchange rate = $1.35 per euro x 105 / 115 = $1.23 per euro

(b)

The real exchange rate represents the exchange rate between two currencies that is adjusted for relative price level between two countries.

(c)

% change in nominal rate = % Change in real rate + % change in PEU - % Change in PUS

(d)

Predicted % change in nominal rate = 1% + 10% - 5% = 6%

(e)

In nominal terms, home currency has appreciated by 10%. But in real terms, home currency has appreciated but by 1% only (per data).

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