Which of the following events will cause the largest real depreciation for the domestic economy?
A)a 6% reduction in E and a 6% increase in the foreign price level (P*)
B)a 6% increase in the domestic price level (P)and a 6% reduction in P*
C)a 6% reduction in E and a 6% reduction in P*
D)a 3% increase in E
E) a 2% increase in E and a 2% increase in P

Question

Quizplus · Accepted Answer

A 6% reduction in the exchange rate (E) means the domestic currency is depreciating in value. Additionally, a 6% increase in the foreign price level (P*) means foreign goods are becoming relatively more expensive. Therefore, the combination of these two factors would cause the largest real depreciation for the domestic economy. Option B results in an equal percentage change in both the domestic price level (P) and the foreign price level (P*) and hence will not have any effect on the real exchange rate. Option C involves a reduction in both E and P* but the reduction in E has a greater impact hence the real depreciation is smaller compared to option A. Option D involves a 3% increase in E which results in an appreciation of the domestic currency, thus leading to a real appreciation instead of a depreciation. Option E involves an increase in both E and P, but the percentage change in each variable is small, hence the overall impact on the real exchange rate is relatively smaller.

Which of the Following Events Will Cause the Largest Real