A

1) The multilateral real exchange rates are calculated based on many currencies. The multilateral exchange rates help to determine the dynamics and performance of a country’s currency relative to major world currencies. In calculating multilateral exchange rates, one takes some world currencies, assigns them relative weights, and then computes the country’s currency exchange rate.

International competitiveness is the relative price of domestic goods in terms of a particular foreign currency. In this regard, a country’s competitiveness increases with a decline in the relative price of its goods. Therefore, the nominal exchange rate is not a good indicator of international competitiveness as changes in relative prices also affect trade across countries. The multilateral real exchange rate (ε= EP/P*) is a good indicator of competitiveness as it corrects the nominal exchange rate (E, which is the foreign currency/domestic currency per unit ratio) by foreign price (P*) and domestic price (P). The E and P* are averages based on long-run domestic trade patterns.

The underlying model uses the relative prices of goods between countries and is based on the assumption that the market is imperfect i.e., both domestic and foreign goods are not perfect substitutes of one another and hence the adjustment of ε. If the adjustment was immediate and the tradable goods substitutable i.e., the same as between countries, then there would be no variation in competitiveness as purchasing power parity (PPP) would be a constant. But, this is usually not the case. The real exchange rate, therefore, applies to international trade, where there is a departure from the law of one price and thus a useful measure of international competitiveness.

2) False. An increase in the real exchange rate is an indication that the foreign price (P*) of particular tradable goods has increased when compared to the domestic price (P). This means that the real value of the U.S. currency (dollar) has declined i.e. the purchasing power of the dollar, relative to a foreign currency (country B, e.g. the Japanese Yen), has gone down. More dollars will be needed to buy a yen as the loss of purchasing power of the dollar means that the yen gains more value relative to the dollar. This means that importers in the U.S. will spend more to import tradable goods from country B when the real exchange rate has appreciated. Thus, following an increase in the real exchange rate, a country’s expenditure on imports will rise.