Question

When the ratio of domestic prices to foreign prices rises:

Select one:

a. the real exchange rate appreciates only when the nominal exchange rate depreciates.

b. None of these

c. the real exchange rate appreciates even when the nominal exchange rate is constant.

d. the real exchange rate depreciates.

e. the real exchange rate appreciates only when the nominal exchange rate appreciates.

Answer 1

Real Exchange rate = Nominal Exchange rate * Domestic price/Foreign price (D/F)

In the given question D/F rises. A increase in D/F will increase real exchange rate only when nominal exchange rate is constant or it appreciates with the D/F ratio. In case nominal e.r is constant, real e.r rises by the ratio of D/F while if nominal e.r also increases, real e.r will rise due to both variables. The only way real exchange rate can depreciate is if nominal exchange rate decreases more than the increase in D/F ratio. However when domestic prices rise, foreigners demand more of the home currency. This appreciates the exchange rate.

Based on the above discussion, option a cannot be right, because a depreciation in nominal rates can depreciate real rates. option d is incorrect as well because a price ratio rises, real e.r appreciates and not depreciates.

Coming back to the original discussion, it is clear from the from the formula as well, that real e.r appreciates due to rise in price ratio when nominal e.r. is constant and also when nominal e.r appreciates. So option e is incorrect as for the real exchange rate to appreciate it is not compulsive for this to happen only when nominal e.r. appreciates and is even possible when nominal e.r is constant. Hence option c is correct.