Nominal vs. Real Exchange Rates Quiz
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Questions and Answers

What does the absolute Purchasing Power Parity (PPP) hypothesis imply about the real exchange rate?

  • The real exchange rate depends on inflation rates.
  • The real exchange rate is always less than 1.
  • The real exchange rate can vary widely.
  • The real exchange rate is equal to 1. (correct)

    • What is the implication of Relative PPP for the nominal exchange rate when foreign inflation is greater than domestic inflation?

  • The real exchange rate increases.
  • The domestic currency depreciates.
  • The domestic currency remains unchanged.
  • The domestic currency appreciates. (correct)

    • In the long run, what is primarily reflected in the nominal exchange rate?

  • Interest rate differentials.
  • Changes in foreign reserves.
  • Short-term market fluctuations.
  • Price level differences. (correct)

    • Which statement accurately describes the relationship between Absolute PPP and Relative PPP?

    <p>Absolute PPP implies Relative PPP.</p> Signup and view all the answers

    What is a characteristic of countries with low and stable inflation regarding their exchange rates?

    <p>Close co-movement of nominal and real exchange rates.</p> Signup and view all the answers

    What condition must hold for the real exchange rate to remain constant according to Relative PPP?

    <p>Inflation must be equal.</p> Signup and view all the answers

    What primarily drives changes in the real exchange rate in the short run?

    <p>Changes in the nominal exchange rate.</p> Signup and view all the answers

    When discussing fluctuations in the real exchange rate with a fixed nominal exchange rate, what is the expected behavior?

    <p>The real exchange rate is much less volatile.</p> Signup and view all the answers

    What does an increase in the nominal exchange rate E indicate regarding the AUD and USD?

    <p>The AUD is appreciating against the USD.</p> Signup and view all the answers

    Which statement correctly describes fixed exchange rate regimes?

    <p>They limit the effectiveness of monetary policy in stabilizing domestic demand.</p> Signup and view all the answers

    How is the real exchange rate (RER) calculated?

    <p>RER = P / (P f / E)</p> Signup and view all the answers

    What happens when the real exchange rate (RER) is greater than 1?

    <p>Foreign goods seem cheap in real terms.</p> Signup and view all the answers

    What primarily drives the supply of domestic currency in foreign exchange markets?

    <p>Increased demand for foreign goods and services</p> Signup and view all the answers

    Which of the following describes the purpose of exchange rates in an economy?

    <p>They determine the relative value of a country's exports and imports.</p> Signup and view all the answers

    What does it imply if RER < 1?

    <p>Foreign goods appear expensive in real terms.</p> Signup and view all the answers

    What can cause a shift in the demand for domestic currency?

    <p>Higher safety concerns leading to domestic purchases</p> Signup and view all the answers

    Which of the following statements about nominal exchange rates is correct?

    <p>They represent the relative price of one currency in terms of another.</p> Signup and view all the answers

    An appreciation of a currency usually results from which of the following?

    <p>Increased global investments in domestic currency</p> Signup and view all the answers

    Which factor can increase the demand for foreign currencies?

    <p>Demand shift towards foreign goods</p> Signup and view all the answers

    Which aspect of exchange rates does purchasing power parity focus on?

    <p>Long-term exchange rates.</p> Signup and view all the answers

    What is the equilibrium nominal exchange rate dependent on?

    <p>The balance between supply of and demand for domestic currency</p> Signup and view all the answers

    A flight to safety in times of market turbulence typically leads to what effect on domestic currency?

    <p>Increased demand for domestic currency</p> Signup and view all the answers

    Exchange rate determination through supply and demand models encompasses which of the following concepts?

    <p>Purchasing Power Parity (PPP)</p> Signup and view all the answers

    What type of economic condition can lead to changing demand patterns for domestic goods and services?

    <p>Popularity of newly invented domestic goods</p> Signup and view all the answers

    What effect does a decrease in the real exchange rate have on foreign and domestic goods?

    <p>Decreases imports and increases exports</p> Signup and view all the answers

    Which factors contribute to the change in the real exchange rate as represented in the formula gRER = gE + gP − gP f?

    <p>Fluctuations in nominal exchange rates and relative price levels</p> Signup and view all the answers

    What distinguishes a floating exchange rate from a fixed exchange rate?

    <p>Floating rates are determined by market supply and demand; fixed rates are set by policy-makers</p> Signup and view all the answers

    How is a fixed exchange rate maintained by policy-makers?

    <p>By being willing to buy and sell foreign currency or commodities</p> Signup and view all the answers

    What is the Law of One Price primarily associated with?

    <p>The idea that tradeable goods should sell for the same price everywhere in a common currency</p> Signup and view all the answers

    What does a currency union represent in terms of exchange rate regime?

    <p>A strong form of currency standard</p> Signup and view all the answers

    What happens to the exchange rate regime if reserves are exhausted?

    <p>It collapses</p> Signup and view all the answers

    Which of the following is NOT a typical characteristic of a managed float exchange rate?

    <p>Strictly adheres to a fixed currency value</p> Signup and view all the answers

    A decrease in the real exchange rate (RER) makes foreign goods more expensive and domestic goods cheaper.

    <p>False</p> Signup and view all the answers

    In a currency union, the price of currency is fixed in terms of foreign currency.

    <p>True</p> Signup and view all the answers

    Purchasing Power Parity (PPP) implies that tradeable goods should sell for different prices across different markets.

    <p>False</p> Signup and view all the answers

    A floating exchange rate is determined solely by government policy.

    <p>False</p> Signup and view all the answers

    The change in real exchange rate can occur even if the nominal exchange rate is fixed.

    <p>True</p> Signup and view all the answers

    Crisis occurs when the current exchange rate regime has strong credibility.

    <p>False</p> Signup and view all the answers

    A fixed exchange rate is maintained only by the buying and selling of gold.

    <p>False</p> Signup and view all the answers

    An increase in the nominal exchange rate indicates a strengthening of the domestic currency.

    <p>False</p> Signup and view all the answers

    An increase in the nominal exchange rate E results in the depreciation of the AUD against the USD.

    <p>False</p> Signup and view all the answers

    Real exchange rates indicate the relative price of a consumption basket in terms of another currency.

    <p>True</p> Signup and view all the answers

    Absolute Purchasing Power Parity (PPP) implies that the real exchange rate is approximately constant.

    <p>True</p> Signup and view all the answers

    In a fixed exchange rate regime, monetary policy is very effective at influencing domestic demand.

    <p>False</p> Signup and view all the answers

    If foreign inflation is lower than domestic inflation, the domestic currency will appreciate.

    <p>False</p> Signup and view all the answers

    When the real exchange rate (RER) is greater than 1, foreign goods appear expensive in real terms.

    <p>False</p> Signup and view all the answers

    The bilateral nominal exchange rate can be expressed as either a direct quote or an indirect quote.

    <p>True</p> Signup and view all the answers

    Relative PPP involves changes in the nominal exchange rate being equal to the inflation differential between two countries.

    <p>True</p> Signup and view all the answers

    Purchasing power parity suggests that nominal exchange rates do not reflect relative price levels between countries.

    <p>False</p> Signup and view all the answers

    In the long run, exchange rates are influenced primarily by short-run fluctuations.

    <p>False</p> Signup and view all the answers

    Under fixed nominal exchange rates, the real exchange rate is more volatile compared to floating nominal exchange rates.

    <p>False</p> Signup and view all the answers

    An appreciation in the real exchange rate corresponds to a decrease in the price of foreign goods, making them relatively more expensive.

    <p>False</p> Signup and view all the answers

    Exchange rates can significantly influence international capital flows and interest rates between countries.

    <p>True</p> Signup and view all the answers

    A depreciation of the domestic currency occurs when foreign inflation is greater than domestic inflation.

    <p>True</p> Signup and view all the answers

    The Law of One Price applies to individual goods but not to the whole consumption basket.

    <p>False</p> Signup and view all the answers

    In the short run, real exchange rate variations are primarily linked to changes in the nominal exchange rate.

    <p>True</p> Signup and view all the answers

    Increased demand for foreign goods and services can lead to a higher supply of domestic currency.

    <p>True</p> Signup and view all the answers

    Demand for domestic currency decreases when foreign households want to buy domestic goods and services.

    <p>False</p> Signup and view all the answers

    Higher national GDP generally leads to changing patterns of expenditure and increased demand for domestic goods.

    <p>True</p> Signup and view all the answers

    The equilibrium nominal exchange rate is established when the supply of domestic currency equals the demand for foreign currency.

    <p>False</p> Signup and view all the answers

    In times of market turbulence, investors tend to shift to investing in foreign assets.

    <p>False</p> Signup and view all the answers

    Changing tastes can influence the demand for foreign assets.

    <p>True</p> Signup and view all the answers

    A flight to safety usually increases the demand for domestic goods and assets.

    <p>True</p> Signup and view all the answers

    Expenditure patterns change primarily due to fluctuations in nominal exchange rates.

    <p>False</p> Signup and view all the answers

    How does a decrease in the real exchange rate (RER) impact imports and exports?

    <p>A decrease in RER makes foreign goods more expensive and domestic goods cheaper, leading to a decrease in imports and an increase in exports.</p> Signup and view all the answers

    What factors can lead to changes in the real exchange rate according to the formula gRER = gE + gP − gP f?

    <p>Changes in the nominal exchange rate (gE) and inflation differentials (π − π f) can lead to changes in the real exchange rate.</p> Signup and view all the answers

    What is one key characteristic of a floating exchange rate regime?

    <p>In a floating exchange rate regime, the currency's value is determined by market forces of supply and demand.</p> Signup and view all the answers

    What occurs if policy-makers exhaust their reserves in a fixed exchange rate regime?

    <p>If reserves are exhausted, the fixed exchange rate regime collapses, leading to potential currency devaluation.</p> Signup and view all the answers

    What does the Law of One Price imply about traded goods in different markets?

    <p>The Law of One Price implies that tradeable goods should sell for the same price across different markets when prices are expressed in a common currency.</p> Signup and view all the answers

    In the context of currency appreciation, what does an increase in the nominal exchange rate E signify?

    <p>An increase in the nominal exchange rate E typically indicates a depreciation of the domestic currency against foreign currency.</p> Signup and view all the answers

    What is the main difference between nominal and real exchange rates?

    <p>Nominal exchange rates refer to the relative price of one currency in terms of another, while real exchange rates compare the relative price of a consumption basket between countries.</p> Signup and view all the answers

    What is a currency union, and how does it relate to exchange rate regimes?

    <p>A currency union is a strong form of currency standard where member countries adopt a shared currency, often leading to fixed exchange rates between them.</p> Signup and view all the answers

    How does a fixed exchange rate regime affect a country's monetary policy?

    <p>In a fixed exchange rate regime, monetary policy is less effective because it needs to maintain the exchange rate rather than responding solely to domestic economic conditions.</p> Signup and view all the answers

    How does inflation affect the real exchange rate based on the relationship between domestic and foreign inflation rates?

    <p>Domestic inflation higher than foreign inflation leads to depreciation of the domestic currency, increasing the real exchange rate.</p> Signup and view all the answers

    What does an increase in the bilateral nominal exchange rate indicate about the currencies involved?

    <p>An increase in the nominal exchange rate indicates the appreciation of the foreign currency and the depreciation of the domestic currency.</p> Signup and view all the answers

    What happens to foreign goods when the real exchange rate (RER) is greater than 1?

    <p>When RER &gt; 1, foreign goods become cheaper in real terms compared to domestic goods.</p> Signup and view all the answers

    In terms of supply and demand, what primarily drives short-run fluctuations in exchange rates?

    <p>Short-run fluctuations in exchange rates are primarily driven by changes in supply and demand for currencies based on factors like interest rates and economic news.</p> Signup and view all the answers

    How is purchasing power parity (PPP) related to the long-term exchange rates?

    <p>Purchasing power parity suggests that in the long run, exchange rates will adjust so that identical goods cost the same in different countries when expressed in a common currency.</p> Signup and view all the answers

    What happens when there is greater domestic inflation compared to foreign inflation in terms of exchange rates?

    <p>When domestic inflation is higher than foreign inflation, the domestic currency is expected to depreciate in the foreign exchange market.</p> Signup and view all the answers

    What is the expected impact on capital flows when there are anticipated changes in exchange rates?

    <p>Anticipated changes in exchange rates can influence international capital flows, as investors seek better returns in countries with expected currency appreciation.</p> Signup and view all the answers

    Explain how the concept of Absolute Purchasing Power Parity relates to overall consumption baskets between countries.

    <p>Absolute Purchasing Power Parity suggests that the price levels of a complete consumption basket should be equal when adjusted for the nominal exchange rate.</p> Signup and view all the answers

    What is the implication of Relative PPP when it comes to the relationship between inflation rates in two countries?

    <p>Relative PPP implies that the change in the nominal exchange rate equals the difference in inflation rates between two countries.</p> Signup and view all the answers

    Discuss the long-term and short-term implications of purchasing power parity on nominal exchange rates.

    <p>In the long run, nominal exchange rates reflect price level differences, while in the short run, they are influenced by fluctuations in actual market conditions.</p> Signup and view all the answers

    What does it mean for the real exchange rate (RER) to approximate 1 under Absolute PPP?

    <p>A real exchange rate close to 1 indicates that the purchasing power of money is the same in both countries being compared.</p> Signup and view all the answers

    How does the inflation differential between domestic and foreign economies affect the appreciation or depreciation of the domestic currency according to Relative PPP?

    <p>If foreign inflation is higher than domestic inflation, the domestic currency appreciates; if the reverse occurs, the domestic currency depreciates.</p> Signup and view all the answers

    Describe the behavior of the real exchange rate under a fixed nominal exchange rate regime.

    <p>Under a fixed nominal exchange rate regime, the real exchange rate experiences less volatility but can still vary due to other economic factors.</p> Signup and view all the answers

    In what scenarios does nominal exchange rate volatility primarily affect the real exchange rate?

    <p>Nominal exchange rate volatility primarily impacts the real exchange rate during short-term fluctuations in the market.</p> Signup and view all the answers

    What are the implications of domestic currency depreciation in terms of foreign purchasing power?

    <p>Domestic currency depreciation makes foreign goods more expensive for consumers in the domestic market.</p> Signup and view all the answers

    What factors can increase the demand for domestic currency in the foreign exchange market?

    <p>Increased demand for domestic goods and services or higher real returns locally can increase demand for domestic currency.</p> Signup and view all the answers

    How does a flight to safety during market turbulence affect the supply of domestic currency?

    <p>A flight to safety typically decreases the supply of domestic currency as investors prefer stable assets.</p> Signup and view all the answers

    What role does changing tastes play in influencing the demand for foreign goods?

    <p>Changing tastes can lead to an increased demand for foreign goods, thus affecting the supply of domestic currency.</p> Signup and view all the answers

    Explain how higher national GDP influences exchange rates.

    <p>Higher national GDP can lead to increased demand for both foreign and domestic goods and services, shifting exchange rates accordingly.</p> Signup and view all the answers

    What is the impact of increased real returns abroad on foreign currency demand?

    <p>Increased real returns abroad typically boost the demand for foreign currency as investors seek higher yields.</p> Signup and view all the answers

    How does the concept of purchasing power parity relate to nominal exchange rates?

    <p>Purchasing power parity suggests that nominal exchange rates should reflect the relative price levels of goods in different countries.</p> Signup and view all the answers

    Define the equilibrium nominal exchange rate.

    <p>The equilibrium nominal exchange rate is achieved when the supply of and demand for a currency are equal.</p> Signup and view all the answers

    What can lead to a shift in the supply of AUD in the forex market?

    <p>Factors like increased demand for foreign goods or higher national GDP can lead to a shift in the supply of AUD.</p> Signup and view all the answers

    Makes foreign goods cheaper and domestic goods more expensive, increases imports and/or decreases exports, decreasing net ______

    <p>exports</p> Signup and view all the answers

    A key idea in the Law of One Price is that tradeable goods should sell for the same price everywhere, when prices are denominated in a common ______

    <p>currency</p> Signup and view all the answers

    RER can change due to changes in ______ exchange rate E and/or changes in relative price levels P/P f

    <p>nominal</p> Signup and view all the answers

    A floating exchange rate is ______ determined relative price of currency based on supply and demand.

    <p>market</p> Signup and view all the answers

    Crisis occurs when the current exchange rate regime is not ______

    <p>credible</p> Signup and view all the answers

    A currency union is a strong form of ______ standard.

    <p>currency</p> Signup and view all the answers

    An increase in the nominal exchange rate indicates a depreciation of the ______ currency.

    <p>domestic</p> Signup and view all the answers

    The real exchange rate can adjust even if the nominal exchange rate is ______.

    <p>fixed</p> Signup and view all the answers

    Absolute PPP hypothesis assumes that the law of one price holds for the whole consumption ______.

    <p>basket</p> Signup and view all the answers

    If Relative PPP holds, domestic currency appreciates when foreign inflation is greater than domestic ______.

    <p>inflation</p> Signup and view all the answers

    In the long run, the nominal exchange rate mostly reflects price level differences and the real exchange rate is approximately ______.

    <p>constant</p> Signup and view all the answers

    Relative PPP requires that the change in real exchange rate equals the inflation differential, represented as gE = πf − ______.

    <p>π</p> Signup and view all the answers

    Domestic currency depreciates if foreign inflation is less than domestic ______.

    <p>inflation</p> Signup and view all the answers

    Short-run changes in the real exchange rate are usually due to variations in the nominal exchange rate ______.

    <p>E</p> Signup and view all the answers

    With a floating nominal exchange rate, there is a close co-movement of nominal and real exchange rates, especially in countries with low and stable ______.

    <p>inflation</p> Signup and view all the answers

    Purchasing Power Parity provides a guideline for long-run exchange rate dynamics when a country is experiencing high ______.

    <p>inflation</p> Signup and view all the answers

    The ______ exchange rate is the relative price of one currency in terms of another.

    <p>nominal</p> Signup and view all the answers

    When RER < 1, foreign goods seem ______ in real terms.

    <p>expensive</p> Signup and view all the answers

    An increase in the nominal exchange rate E indicates an appreciation of the ______ against the USD.

    <p>AUD</p> Signup and view all the answers

    Countries with ______ exchange rates find their monetary policy less effective at stabilizing domestic demand.

    <p>fixed</p> Signup and view all the answers

    The ______ exchange rate reflects the relative price of a consumption basket in terms of another currency.

    <p>real</p> Signup and view all the answers

    Changes in GDP can occur through fluctuations in the quantities of exports and ______.

    <p>imports</p> Signup and view all the answers

    Purchasing power parity connects expected changes in exchange rates with ______ rates across countries.

    <p>interest</p> Signup and view all the answers

    In an indirect quote, the foreign currency is expressed as ______ currency per unit of domestic currency.

    <p>domestic</p> Signup and view all the answers

    Currencies are traded in foreign ______ markets.

    <p>exchange</p> Signup and view all the answers

    Domestic households and firms supply domestic currency to buy foreign ______, services, and assets.

    <p>goods</p> Signup and view all the answers

    An increased demand for foreign goods can arise from changing ______ and higher national GDP.

    <p>tastes</p> Signup and view all the answers

    Higher real returns abroad can lead to increased demand for foreign ______.

    <p>assets</p> Signup and view all the answers

    The equilibrium nominal exchange rate occurs when supply equals ______.

    <p>demand</p> Signup and view all the answers

    Increased demand for domestic goods can be driven by changing tastes and higher national ______.

    <p>GDP</p> Signup and view all the answers

    A flight to safety in times of market turbulence often leads to increased demand for domestic ______.

    <p>currency</p> Signup and view all the answers

    Exchange rate determination using supply and demand models helps explain the concepts of ______ and depreciation.

    <p>appreciation</p> Signup and view all the answers

    Study Notes

    Nominal vs. Real Exchange Rates

    • The nominal exchange rate is the relative price of one currency in terms of another
      • There are two conventions for a bilateral nominal exchange rate:
        • Direct Quote: Domestic currency per unit foreign currency
        • Indirect Quote: Foreign currency per unit domestic currency
    • The real exchange rate is the relative price of one consumption basket in terms of another
      • Real exchange rate (RER) can be calculated by: RER = (P * E) / Pf, where P is the domestic price level, Pf is the foreign price level in foreign currency and E is the nominal exchange rate.
      • When RER > 1, foreign goods seem cheap in real terms
      • When RER < 1, foreign goods seem expensive in real terms
    • Increase in RER (appreciation): Makes foreign goods cheaper and domestic goods more expensive, decreasing net exports.
    • Decrease in RER (depreciation): Makes foreign goods more expensive and domestic goods cheaper, increasing net exports.

    Exchange Rate Regimes

    • Exchange rate regimes are a macroeconomic policy choice
    • Nominal exchange rates can be either floating or fixed.
      • Floating: market-determined relative price of currency where currency values are determined by the supply and demand for currencies.
      • Fixed: policy-makers set the value of the currency.

    Purchasing Power Parity (PPP)

    • The law of one price states that tradeable goods should sell for the same price everywhere, once prices are denominated in a common currency.
    • Absolute Purchasing Power Parity (PPP) assumes that the law of one price holds for the whole consumption basket, i.e., RER = 1. It implies that the real purchasing power is the same in both countries.
    • Relative PPP is the idea that the real exchange rate is constant in the long-run and implies that changes in nominal exchange rate gE equal to the inflation differential πf − π.
      • If Relative PPP holds:
        • Domestic currency appreciates (gE > 0) if foreign inflation is greater than domestic inflation (πf > π)
        • Domestic currency depreciates (gE < 0) if foreign inflation is less than domestic inflation (πf < π)
    • Relative PPP does not imply Absolute PPP
    • In the long run:
      • Nominal exchange rate E mostly reflects price level differences P/Pf and the RER ≈ constant
      • PPP provides a good guide to assessing long-run exchange rate dynamics, especially for countries experiencing high inflation.
    • In the short-run:
      • Changes in the real exchange rate are mostly due to changes in the nominal exchange rate E.
      • PPP provides a poor guide to short-run exchange rate dynamics, especially for countries with low and stable inflation rates.

    Supply & Demand for Foreign Exchange

    • The supply of domestic currency is driven by:
      • Domestic households and firms that want foreign currency to buy foreign goods, services and assets.
    • The demand for domestic currency is driven by:
      • Foreign households and firms that want domestic currency to buy domestic goods, services and assets.
    • The equilibrium nominal exchange rate occurs when the supply equals the demand.
    • Factors that shift the supply of domestic currency:
      • Increased demand for foreign goods and services
      • Increased demand for foreign assets
    • Factors that shift the demand for domestic currency:
      • Increased demand for domestic goods and services
      • Increased demand for domestic assets

    Nominal vs. Real Exchange Rates

    • The nominal exchange rate is the price of one currency in terms of another.
    • Direct quote uses domestic currency per unit of foreign currency.
    • Indirect quote uses foreign currency per unit of domestic currency.
    • Appreciation of a currency occurs when the value of the currency increases relative to another currency.
    • Depreciation of a currency occurs when the value of the currency decreases relative to another currency.

    Real Exchange Rate

    • The real exchange rate is the relative price of one consumption basket in terms of another.
    • Calculated by dividing the domestic price level by the foreign price level converted into domestic currency.
    • When the real exchange rate is greater than 1, foreign goods appear cheaper in real terms.
    • When the real exchange rate is less than 1, foreign goods appear more expensive in real terms.
    • Changes in the real exchange rate can be due to changes in the nominal exchange rate or changes in relative price levels.

    Exchange Rate Regimes

    • Exchange rate regimes are macroeconomic policy choices.
    • Nominal exchange rates can be floating, fixed, or a combination of both.
    • Floating exchange rates are determined by market supply and demand.
    • Fixed exchange rates are established by policymakers.
    • A currency union is a fixed exchange rate system with no independent monetary policy.

    Purchasing Power Parity (PPP)

    • PPP is a theory that states that the price of a good should be the same in all countries after accounting for exchange rates.
    • Absolute PPP states that the price level of a country's consumption basket is the same in all countries after accounting for exchange rates.
    • Relative PPP states that changes in the nominal exchange rate are equal to the inflation differential between two countries.

    Nominal Exchange Rates in the Short Run

    • Supply and demand for foreign exchange determines the nominal exchange rate in the short run.
    • Supply of domestic currency comes from domestic residents who want to buy foreign goods, services, and assets.
    • Demand for domestic currency comes from foreign residents who want to buy domestic goods, services, and assets.
    • Changes in demand for foreign goods and services, demand for foreign assets, demand for domestic goods and services, and demand for domestic assets can shift the supply and demand curves for foreign exchange.

    Nominal vs. Real Exchange Rates

    • The nominal exchange rate is the price of one currency in terms of another.
    • An increase in the nominal exchange rate corresponds to an appreciation of the first currency against the second.
    • The real exchange rate is the relative price of a basket of goods in one country compared to another.
    • It is calculated by dividing the domestic price level by the foreign price level adjusted for the nominal exchange rate.
    • A real appreciation makes foreign goods cheaper and domestic goods more expensive.
    • A real depreciation makes foreign goods more expensive and domestic goods cheaper.

    Exchange Rate Regimes

    • A country can choose to have a floating or fixed exchange rate regime.
    • In a floating exchange rate regime, the exchange rate is determined by the supply and demand of currencies in the market.
    • In a fixed exchange rate regime, the government sets the exchange rate, and promises to buy or sell enough of its currency to maintain it.
    • A currency union is an example of a strong form of currency standard, where several countries share a single currency.

    Purchasing Power Parity (PPP)

    • PPP is the theory that the exchange rate between two currencies should equal the ratio of the price levels of a basket of goods in the two countries.
    • Absolute PPP states that the price levels of a basket of goods should be the same in both countries when converted to a common currency.
    • Relative PPP states that changes in the nominal exchange rate will be equal to the difference in inflation rates between the two countries.
    • PPP is a good guide to long-run exchange rate dynamics, but not to short-run dynamics, particularly for countries with low and stable inflation rates.

    Nominal Exchange Rates in the Short Run

    • In the short run, the nominal exchange rate is determined by supply and demand for currencies in the foreign exchange market.
    • Factors affecting the supply of domestic currency include the demand for foreign goods and services and assets.
    • Factors affecting the demand for domestic currency include the demand for domestic goods and services and assets.
    • An increase in the supply of domestic currency will cause the currency to depreciate, while an increase in demand will cause it to appreciate.

    Nominal vs. Real Exchange Rates

    • The nominal exchange rate is the price of one currency in terms of another.
    • It is commonly expressed as an indirect quote: the amount of foreign currency needed to purchase one unit of the domestic currency.
    • The real exchange rate is the relative price of a consumption basket in one country compared to another.
    • It takes into account the price levels of both countries.
    • A higher real exchange rate implies that foreign goods are relatively cheaper in real terms.

    Exchange Rate Regimes

    • A fixed exchange rate regime involves the government fixing the price of its currency in terms of another currency or commodity.
    • A floating exchange rate regime allows the exchange rate to be determined by market forces of supply and demand.
    • Australia has a floating exchange rate regime since 1983.

    Purchasing Power Parity (PPP)

    • The law of one price states that identical goods should trade for the same price in different countries when prices are expressed in a common currency.
    • Absolute PPP implies that the real exchange rate is always equal to 1.
    • Relative PPP implies that the percentage change in the nominal exchange rate equals the inflation differential between the two countries.
    • PPP is more relevant in the long run, especially for countries with high inflation levels.

    Nominal Exchange Rates in the Short-Run: Supply & Demand

    • The exchange rate is determined by the supply and demand for the currency in the foreign exchange market.
    • The supply of a currency comes from domestic residents seeking foreign currency to buy foreign goods, services, or assets.
    • The demand for a currency comes from foreigners seeking domestic currency to buy domestic goods, services, or assets.
    • Changes in tastes, national GDP, real returns abroad, and flight to safety can shift the supply and demand curves for a currency, leading to changes in the exchange rate.

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    Introductory Macroeconomics Lecture 19: Exchange Rates I PDF

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    Test your understanding of nominal and real exchange rates. This quiz covers definitions, calculations, and the implications of changes in exchange rates on trade. Understanding these concepts is crucial for economics students and professionals.

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