Question

Consider the following questions regarding the real exchange rate (q) as well as the two purchasing power parity (PPP) conditions that are discussed in the textbook: (a) Briefly define and interpret the real exchange rate. (b) What does it mean if q is decreasing over time? Briefly explain. (c) What restriction(s) do the PPP conditions place on the real exchange rate? Briefly explain. (d) If domestic prices are rising slower than foreign prices over time then, according to the PPP conditions, what effect(s) should that have on the nominal exchange rate (E)? Briefly explain.

Answer 1

Part (a)

The real exchange rate is the relative price of the goods of two countries. That is, the real exchange rate tells us the rate at which the goods of one country are traded for the goods of another. The real exchange rate is sometimes called the terms of trade.

Part (b)

A decrease in the real exchange rate over time means that there is a decrease in the relative price of domestic goods in terms of foreign goods—is called a real depreciation.If the real exchange rate is low, foreign goods are relatively expensive, and domestic goods are relatively cheap.

Part (c)

The absolute purchasing power parity (PPP) theory holds that the prices of identical goods should be the same in all countries, differing only by the cost of transport and any import duties. This theory implies that the real exchange rate should be constant. Assuming real exchange rate is equal to 1

This states that if the foreign price level increases faster than the domestic price level, there is an increase in price ratio and the nominal exchange rate must appreciate if PPP is to prevail.

PPP also implies net exports are highly sensitive to small movements in the real exchange rate. Because the net-exports curve is flat, changes in saving or investment do not influence the real or nominal exchange rate. Second, because the real exchange rate is fixed, all changes in the nominal exchange rate result from changes in price levels.

Part (d)

Relative PPP thus translates absolute PPP from a statement about price and exchange rate levels into one about price and exchange rate changes. It asserts that prices and exchange rates change in a way that preserves the ratio of each currency’s domestic and foreign purchasing powers.

An appreciation of the domestic currency is an increase in the price of the domestic currency in terms of a foreign currency. This will make foreign goods cheaper for the people and domestic goods expensive for the people