The correct answer is B (5%).

Explanation: The real exchange rate change is calculated using the formula: $(1 + \text{Nominal Appreciation}) \times \frac{(1 + \text{Foreign Inflation})}{(1 + \text{Domestic Inflation})} - 1$ Substituting the given values: $(1 + 6\%) \times \frac{(1 + 2\%)}{(1 + 3\%)} - 1 = 1.06 \times \frac{1.02}{1.03} - 1 \approx 0.0497 \text{ or } 5\%$

Alternatively, using the approximate formula: $\text{Nominal Appreciation} + \text{Foreign Inflation} - \text{Domestic Inflation} = 6\% + 2\% - 3\% = 5\%$

Why not A or C?

• A (4%) incorrectly applies the formula without adjusting for inflation rates properly.
• C (7%) swaps the domestic and foreign inflation rates in the calculation, leading to an overestimation.