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Short & Medium Term Exchange Rate Changes

1. What is the "real" exchange rate, and why are changes in it more important than changes in the nominal exchange rate.

2. Does the "real exchange rate" have meaning only for a country, or does it have meaning for a company, as well? Explain.

3. Suppose England's real exchange rate relative to the United States was 1.32. What does this mean? Is there an opportunity to arbitrage the markets? If so, explain how, and if not, explain why not.

4. Suppose England decided to fix its exchange rate relative to the Euro as a precursor to joining the European Monetary Union. Under these circumstances, is it possible for England's real exchange rate to change?

5. Suppose you picked up the Wall Street Journal and read the following headline: "U.S. dollar rises on international markets." After reading the article, you discover that the U.S. dollar did rise against the Canadian dollar, Mexican peso, and Japanese yen, but it fell against the euro, Swiss franc, British pound, Thai baht, and Indian rupee. Is this a case where the Wall Street Journal reporter should have written a more carefully articulated article? Was he/she wrong to make a general statement (i.e., "U.S. dollar rises on international markets") when the dollar moved in different directions against different currencies?

6. Using supply and demand analysis, explain the effect each of the following economic changes has on the Swedish Krone value of the Brazilian real. Also, what effect do these transactions have on the respective countries' monetary bases?
a. A decline in the real interest rate on Krone securities relative to real securities.
b. A rise in Brazilian real GDP relative to Sweden.
c. A decline in Sweden's inflation rate relative to Brazil.
d. The Bank of Brazil intervenes to raise the value of the real.
e. A growing expectation that Brazil will impose exchange controls on the real.

7. Suppose you were an investment portfolio manager, and you were currently satisfied with the composition of your internationally diversified portfolio. What changes would you make in the portfolio if you expected the U.S. money supply to grow rapidly in the future relative to the euro money supply? Explain.

8. What are the major advantages of having a global currency? (What name would you give to this global currency?)
9. Why are fixed exchange rates a problem for any nation coming under speculative pressure?

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1. What is the "real" exchange rate, and why are changes in it more important than changes in the nominal exchange rate.

The real exchange rate is the ratio of foreign to domestic prices, measured in the same currency. It measures a country's competitiveness in international trade.

The real exchange rate is defined as
Real exchange rate = R = e Pf / P

Where
e = dollar price of foreign exchange
and
P and Pf are the price levels here and abroad.

As an example
Suppose:
Exchange rate: ¥105.6500 = $1 Or 1 ¥ = $ 0.009465
Price of a Big Mac in the U.S.: PU.S. = $3.00
Price of Big Mac in Japan: PJapan = ¥265

Thus Price of Big Mac in Japan in dollar terms = ¥265 x 0.009465 = $ 2.52

Therefore Real exchange rate = R = e Pf / P = $ 2.52/ $3.00 = 0.84

The nominal exchange rate is the rate at which an organisation can trade the currency of one country for the currency of another.

The real exchange rate is the rate at which an organisation can trade goods and services of one country for those of another. For example, say the price of a good increases 10% in the UK, and there is also a 10% depreciation in the UK currency against the German currency, the price of the good remains constant for a German despite increase in price for people in the UK.

A rise in real exchange rate or a real depreciation means that goods abroad have become more expensive relative to goods at home. Other things being equal this means that people - both at home and abroad - are likely to switch some of their spending to goods produced at home. This can be described as an increase in competitiveness of our products. Conversely, a decline in R or real depreciation means that our goods have become relatively more expensive or that we have lost competitiveness.

Changes in real exchange rate is more important than changes in the nominal exchange rate as trade in goods and services is more important than trade in currencies. RER is a key relative price in the determination of many real macroeconomic variables including investment, consumption and trade flows

2. Does the "real exchange rate" have meaning only for a country, or does it have meaning for a company, as well? Explain.

Real exchange rate have meaning for a company as well. A high RER means that goods abroad have become more expensive relative to goods at home. This would be good news for a company that wishes to export its goods or services as a rise in RER makes these goods and services more competitive in the international market.

3. Suppose England's real exchange rate relative to the United States was 1.32. What does this mean? Is there an opportunity to arbitrage the markets? If so, explain how, and if not, explain why not.

This means that 1.32 of a product in. US is equivalent to 1 product in England.
Or in more concrete terms using the example of question 1, 1.32 Big Mac in the U.S.
is equivalent to 1 Big Mac in England
This provides an opportunity for arbitrage in the markets.

The current exchange rate is $1.8681 =₤1

Suppose the cost of 1 Big Mac in US = $3.00

England's real exchange rate relative to the United States is 1.32

Therefore price of 1 Big Mac in England = $3.00 / (1.32 * 1.8681) = ₤ ...

Solution Summary

Nine questions dealing with real exchange rate, nominal exchange rate, fixed exchange rate system, monetary bases, exchange controls, internationally diversified portfolio, global currency, speculative pressure.

$2.19