Real exchange rate
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Real Exchange Rate PowerPoint PPT Presentation


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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)

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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.


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