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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
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?


Real exchange rate

  • 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


O vervalued exchange rate
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.


Real exchange rate

  • 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).


Real exchange rate


Real exchange rate

S the reserves that correspond to the country’s balance of payment deficit.

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.