If the annual inflation rate is 3 percent in France and 5 percent in Italy, by how much will the real exchange rate change over a year? Assume that both countries use the euro so their nominal exchange rate cannot change.

Question

Quizplus · Accepted Answer

The real exchange rate adjusts to reflect the relative purchasing power of currencies. If inflation is higher in Italy (5%) than in France (3%), the real value of the euro in Italy decreases compared to France. This means the real exchange rate would effectively decrease by the difference in inflation rates, which is 2 percent. However, since Italy's inflation is higher, making its goods relatively more expensive, the adjustment is negative, leading to a -2 percent change.

If the Annual Inflation Rate Is 3 Percent in France