CFA Level I · CFA Level I Exam · Capital Flows and the FX Market
Over one year, the nominal exchange rate of the domestic currency (quoted as domestic per foreign) is unchanged. Domestic inflation is 6% and foreign inflation is 2%. The domestic currency's real exchange rate against the foreign currency has most likely:
The domestic currency has appreciated in real terms by about 4%. With the nominal rate fixed, domestic inflation exceeds foreign inflation by four percentage points, so domestic goods become relatively more expensive, which is a real appreciation and hurts competitiveness.
- Aappreciated by about 4%.Correct
- Bdepreciated by about 4%.
- Cremained unchanged.
Explanation
With a constant nominal rate, higher domestic inflation raises domestic prices relative to foreign prices, so domestic goods become more expensive abroad. The real rate appreciates by roughly the inflation differential of 6% − 2% = 4%. A depreciation would require lower relative domestic inflation.
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