Suppose that the dollar real exchange rate falls by 10% against the euro, 20% against the pound, and 25% against the yen. If the United States trades equally with each country, what is the percentage decline in the real effective exchange rate?
A) 22.5%
B) 18.3%
C) 15.1%
D) 20.3%

Question

Quizplus · Accepted Answer

To calculate the real effective exchange rate (REER) we need to take the weighted average of the exchange rates with each country, where the weights represent the share of trade with each country. Since the United States trades equally with each country, the weights will be equal. Therefore, the REER can be calculated as:

REER = (1/3)*(0.9*1 + 0.8*1 + 0.75*1)

where 0.9, 0.8, and 0.75 represent the new exchange rates for the euro, pound, and yen respectively (note that we multiply by 1 to convert from a percentage decline to the new exchange rate).

Simplifying the expression we get:

REER = (1/3)*(2.45) = 0.8167

The percentage decline in the REER is then:

100*(1 - 0.8167) = 18.33%

Therefore, the correct answer is B, 18.3%.

Suppose That the Dollar Real Exchange Rate Falls by 10