Nominal And Real Exchange Rates

INTERNATIONAL ECONOMICS ASSIGNMENT SUBMITTED TO: - MISS BEENISH MALIK SUBMITTED BY: - beenish majid BSc ECONOMICS SECTION A SEMESTER VI

Q. a) b) c)

What is:Nominal exchange rate Real exchange rate Trade weighted exchange rate

EXCHANGE RATE An exchange rate is the current market price for which one currency can be exchanged for another. A)

NOMINAL EXCHANGE RATE:

It is defined as the actual foreign exchange quotation in contrast to the real exchange rate, which has been adjusted for changes in purchasing power. MATHEMATICAL FORMULATION The nominal exchange rate e is the price in domestic currency of one unit of a foreign currency. e.Pi=Pi* Here: • e denotes the nominal exchange rate of the domestic currency in terms of the foreign currency • pi denotes the price of good i in domestic in domestic currency • e.pi is the price of the same good in domestic in foreign currency • *pi denotes the price of the same good in the foreign in foreign currency

b) REAL EXCHANGE RATE Basically, the real exchange rate can be defined as the nominal exchange rate that takes the inflation differentials among the countries into account. Its importance stems from the fact that it can be used as an indicator of competitiveness in the foreign trade of a country. The Real Exchange Rate Definitions The various definitions of the real exchange rate can mainly be categorized under two main groups. The first group of definitions is made in line with the purchasing power parity. The second group of definitions, on the other hand, is based on the distinction between the tradable and the non-tradable goods. Purchasing Power Parity According to this definition, the real exchange rate can be defined in the long run as the nominal exchange rate (e) that is adjusted by the ratio of the foreign price level (Pf) to the domestic price level (P). Mathematically, it can be shown as

In terms of this definition, the decline in the rppp can be interpreted as the real appreciation of the exchange rate. The Definition on the Basis of the Tradable and Non-tradable Goods This definition takes the relative price of the tradables and non-tradables in the country as an indicator of the country’s competitiveness level in the foreign trade. The rationale behind this definition is that the cost differential between the countries are closely related with the relative price structures in these economies. Under the assumption that the prices of the tradables will be equal all around the world, the real exchange rate defined on the basis of tradable and non-tradable goods distinction can be mathematically represented as:

In this definition, Pt and Pt* stand for the domestic and international prices of the tradables respectively, while the prices of the non-tradables are denoted by Pn. In this definition, the decline of rr indicates the real appreciation of the domestic currency. TRADE WEIGHTED EXCHANGE RATE It is also known as the effective exchange rate, and is a multilateral exchange rate which is a weighted average of exchange rates of home and foreign currencies, with the weight for each foreign country equal to its share in trade. It measures the average price of a home good relative to the average price of goods of trading partners, using the share of trade with each country as the weight for that country.

Mathematical formulation Based on nominal exchange rates The index is computed as the geometric mean of the bilateral exchange rates of the included currencies. The weight assigned to the value of each currency in the calculation is based on trade data, and is updated annually (the value of the index itself is updated much more frequently than the weightings). The index value at time t is given by the formula: . Where • It and It − 1 are the values of the index at times t and t − 1 • N(t) is the number of currencies in the index at time t • ej,t and ej,t − 1 are the exchange rates of currency j at times t and t − 1 • wj,t is the weight of currency j at time t • and Based on real exchange rates In order to account for countries whose currencies experience differing rates of inflation from that of a specific country the real exchange rate is a more informative measure of that specific country’s currency. This is compensated for by adjusting the exchange rates in the formula using the consumer price index of the respective countries. In this more general case the index value is given by: . Where • pt and pt − 1 are the values of the specific country’s consumer price index at times t and t − 1 • and pj,t and pj,t − 1 are the values of the country j's consumer price index at times t and t − 1