hich of the following events will cause the smallest change in the real exchange rate?(a) A 7% decrease in the nominal exchange rate and a 7% decrease in the foreign price level.(b) A 3% increase in the nominal exchange rate and a 3% increase in the domestic price level.(c) A 7% increase in the domestic price level and a 7% decrease in the foreign price level.(d) A 7% decrease in the nominal exchange rate and a 3% increase in the domestic price level.
Question
hich of the following events will cause the smallest change in the real exchange rate?(a) A 7% decrease in the nominal exchange rate and a 7% decrease in the foreign price level.(b) A 3% increase in the nominal exchange rate and a 3% increase in the domestic price level.(c) A 7% increase in the domestic price level and a 7% decrease in the foreign price level.(d) A 7% decrease in the nominal exchange rate and a 3% increase in the domestic price level.
Solution
The real exchange rate is calculated as (Nominal Exchange Rate * Domestic Price) / Foreign Price.
Let's analyze each option:
(a) A 7% decrease in both the nominal exchange rate and the foreign price level would result in a relatively unchanged real exchange rate, as the decrease in the numerator (nominal exchange rate) is offset by the decrease in the denominator (foreign price level).
(b) A 3% increase in both the nominal exchange rate and the domestic price level would result in an increase in the real exchange rate, as both factors are in the numerator of the equation.
(c) A 7% increase in the domestic price level and a 7% decrease in the foreign price level would result in a significant increase in the real exchange rate, as the numerator increases and the denominator decreases.
(d) A 7% decrease in the nominal exchange rate and a 3% increase in the domestic price level would result in a decrease in the real exchange rate, as the decrease in the nominal exchange rate is not fully offset by the increase in the domestic price level.
Therefore, the event that will cause the smallest change in the real exchange rate is (a) A 7% decrease in the nominal exchange rate and a 7% decrease in the foreign price level.
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