Question

Suppose a country trades with three countries: Brazil (20% of trade), China (45%), and France (35%). Over the last year, the currency of this country has depreciated by 4% against the Brazilian real, appreciated by 3% against the Chinese yuan, and depreciated by 7% against the euro. What has happened to the effective exchange rate of the country? (8 points)

Answer 1

Effective exchange rate if calculated as the weighted average of exchange rate with major trading partners taking the share of trade as weights.

Here the effective exchange rate of the country will be equal to.

= 0.2×exchange rate against brazilian real+ 0.35×exchange rate against Chinese yuan + 0.45×exchange rate against euro.

Now to calculate what happens to the real exchange rate of the country when the exchange rate of the country has depreciated by 4% against brazilian real and appreciated by 3% against Chinese yuan and depreciated by 7% against euro.

So we need to put the value of exchange rate against brazilian real equal to -0.04% since the currency has depreciated. And the we need to put the value of exchange rate against the Chinese yuan equal to 0.03% since the currency has appreciated. And we need to put the value of exchange rate against euro equal to -0.07% since currency has depreciated against euro.

= 0.2 × (-0.04) + 0.35(0.03) + 0.45(-0.07)

= -0.008 + 0.0105 - 0.0315

= -0.029

And in terms of percentage,

= -0.029 × 100

= -2.9%

So the effective exchange rate of the country depreciates by 2.9%