Question

Suppose 30 % of home trade is with country 1 and 70 % is with country 2; Home’s currency depreciates 20 % against country A but appreciates 25 % against country B. What is the change of effective exchange rate for home country? Please explain with steps so I can understand this homework question.

Answer 1

Let's consider

Total value of home trade with both counry is 100 (in our currency) before appreciation or depreciation.

So, Home trade with country A was 30 (in our currency)

and Home trade with country A was 70 (in our currency)

1)

Since, our currency depreciated 20% against country A

So, Trade will be 30 - 30*20% = 24 (in our currency)

2)

Since, our currency Appreciated 25% against country B

So, Trade will be 70 + 70*25% = 87.50 (in our currency)

3) Now,

Total Turnover after appeciation / depreciation

24+87.50 = 111.50

4) % increase in trade = (111.50-100)/100   = 11.50%

So, Our effective exchange rate will increase by 11.50%.

Alternate Method : There is a another way of finding our answer by a simple formula as followed.

Total value of home trade with both counry is 100 (in our currency) before appreciation or depreciation.

So, Home trade with country A was 30 (in our currency)

and Home trade with country A was 70 (in our currency)

Change in effective exchange rate = (home trade country 1 * % of change in country 1) + (home trade

                                                       in country 2 * % of change in country 2)

Change in effective exchange rate = [30*(-20%)] + [70*25%]

Change in effective exchange rate = [-6] + [17.5]

Change in effective exchange rate = -6+17.5

Change in effective exchange rate = 11.5

So, % change in effective exchange rate = 11.5%   (i.e.   (11.5/100)*100)