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5 December, 00:23

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?

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  1. 5 December, 01:24
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    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%.
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