Write down the expression for a country\'s real exchange rate in terms of the no

Question

Write down the expression for a country's real exchange rate in terms of the nominal exchange rate and aggregate price levels, defining your notation carefully. What does a country's real exchange rate measure? What does purchasing power parity theory state that the value of a country's real exchange rate should be? Under what conditions would you expect purchasing power parity to be a valid description of a country's real exchange rate? Now derive an equivalent expression for a country's real exchange rate, in terms of the real exchange rate of traded goods and the relative price of traded to all goods [or traded to non-traded goods]. Define your notation carefully. What does each of these two components of the real exchange rate reflect, in words? Empirically, do we know which is more important for real exchange rates? Suppose there is an increase in domestic demand for non-traded goods relative to traded goods. How would you expect this to affect the country's real exchange rate and why? Suppose the home country imposes a permanent tariff on imported goods from abroad. How do you think this would affect its real exchange rate in the long-run?

Explanation / Answer

Solution a)

We have following expression for real exchange rate:

e= E x DPL / FPL

e= real exchange rate

E= nominal exchange rate

DPL = Domestic price level

FPL = Foreign price level

The real exchange rate (e) measures the value of home currency against other currencies by taking relative prices into account. It is the value, the consumers are actually paying for goods and services.

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