Curiosity 15.2: Why Is There More Than One Exchange Rate?

the United States automatically causes the dollar to depreciate (or, viewed differently, foreign currencies to appreciate) rather than causing money supplies to change. If the depreciation is 3 percent per year, then the 3 percent inflation difference causing U.S. goods and services annually to become 3 percent more expensive is exactly offset, and the international sector remains in balance. The real exchange rate is unchanged.
Automatic forces cause the rate of change of the exchange rate to equal the difference between foreign and U.S. inflation rates. Notice that the change in the exchange rate is ongoing. Each year, the exchange rate must change by an amount equal to the difference in inflation rates. This result is often referred to as purchasing power parity, or PPP:
Rate of change of exchange rate = Foreign inflation rate - Domestic inflation rate
In the example, the rate of change of the U.S. dollar value should be 5 percent less 8 percent equals -3 percent, a depreciation of 3 percent per year. This example is summarized in figure 17.1 for both the fixed and the flexible exchange rate systems.
Curiosity 17.2 What Is the Real Exchange Rate?
In the example in which U.S. inflation is 8 percent and foreign inflation 5 percent, we saw that under a flexible exchange rate system the U.S. dollar would depreciate by 3 percent per year. This 3 percent annual depreciation just offsets the annual relative increase in U.S. prices of 3 percent, so there should be no incentive for anyone to change demand for imports or exports. Although there has been a change in the nominal exchange rate, there has been no change in the real exchange rate.
The nominal exchange rate is the one we read about in the newspaper. It tells us the rate at which our currency exchanges for foreign currencies. The real exchange rate, sometimes called the terms of trade, tells us the rate at which our goods and services exchange for foreign goods and services; it is therefore the exchange rate that influences imports and exports, The real exchange rate can be calculated from the nominal exchange rate as follows:
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The domestic to foreign price ratio in this formula is calculated as the cost of a typical basket of traded goods and services in the United States in U.S. dollars divided by the cost of that same basket in the foreign country in its currency.
From this formula, if U.S. prices increase by 8 percent per year and foreign prices increase by 5 percent per year, then each year the ratio of their price levels increases by about 3 percent, canceled out by the 3 percent fall in the nominal exchange rate. The real exchange rate is unchanged, as it should be in this example. A crucial assumption in the PPP rule of thumb is that the real exchange rate is constant, something we know is not true. Figure 17.2 shows how the real exchange rate can change dramatically in response to factors such as real interest rate differentials.

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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