ABC Economics – Hereafter the variation in nominal and real exchange rates within the Eurozone, Germany and Italy. Data was sourced from the BIS database.
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Explanatory notes on nominal and real exchange rates, and purchasing power parity
- The nominal effective exchange rate is calculated as the geometric weighted average of a basket of bilateral exchange rates. The weights are derived from manufacturing trade flows and capture both direct bilateral trade and third-market competition. The weighting pattern is time-varying with the most recent weights based on trade in 2008 – 10.
- Real EERs are nominal EER adjusted by relative consumer prices i.e. factoring in the Purchasing Power Parity.
- The measure of the differences in price levels is Purchasing Power Parity (PPP). The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies.
- If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1.
- When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms.
- Changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.
- To calculate the nominal exchange rate, simply measure how much of one currency is necessary to acquire one unit of another. The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries.
Increase in real exchange rate
· If a countries real exchange rate is rising it means its goods are becoming more expensive relative to its competitors.
· An increase in the real exchange rate means people in a country can get more foreign goods for an equivalent amount of domestic goods.
· Therefore an increase in the real exchange rate will tend to increase net imports. Foreigners will buy our less expensive exports. It now becomes more attractive to buy imports. This can cause a widening of the current account deficit and lower domestic AD. It will also help reduce inflation.
· Similarly a fall in the real exchange rate should increase net exports as domestic goods are more competitive.