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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= 50 Rs/$ × ($10/Rs250)
= 2 Indian shirts/1 AU shirt
To support the domestic currency the central bank must use the reserves that correspond to the country’s balance of payment deficit.
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.