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# Real Exchange Rate PowerPoint PPT Presentation

Real Exchange Rate. RER = e × (P/Pf) For example, the India VS Australia case Nominal exchange rate e = 50 Rupee/\$ Price of a shirt 250 Rupees in India 10 dollars in Australia Are you better off buying in India or in the Australia? . RER = e × (P/Pf)

Real Exchange Rate

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### Real Exchange Rate

• RER = e × (P/Pf)

• For example, the India VS Australia case

• Nominal exchange rate e = 50 Rupee/\$

• Price of a shirt

• 250 Rupees in India

• 10 dollars in Australia

• Are you better off buying in India or in the Australia?

• RER = e × (P/Pf)

= 50 Rs/\$ × (\$10/Rs250)

= 2 Indian shirts/1 AU shirt

• So shirts are in real terms, twice as expensive in the AU as they are in India

### Overvalued exchange rate

• An overvalued exchange rate is a situation when an exchange rate is higher that its fundamental value.

• Usually occurs in the fixed exchange rate system.

• In a situation of an overvalued exchange rate a government can:

• devalue its nominal fixed exchange rate; bringing the official value into line with its fundamental value

• restrict international transactions;

• buy back its currency in foreign exchange market, in other words, the gov’t becomes the demander of its own currency in the forex market (The most widely used approach).

• To support the domestic currency the central bank must use the reserves that correspond to the country’s balance of payment deficit.

• It cannot do that forever because the amount of reserves is limited.

S

A

B

Official value

0.70 £/\$

Fundamental value

0.65 £/\$

D

Q of \$

At official exchange rate of 0.70 £/\$ is above the fundamental/market value;

The \$ (against £) is overvalued

Excess supply of \$ in the foreign exchange market: the length of AB

To keep the official exchange rate from falling down, the gov’t could purchase a quantity of \$ with £ in foreign exchange market equal to length of AB.