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REAL EXCHANGE RATE

The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. For example, suppose that you go shopping and find that a pound of Swiss cheese is twice as expensive as a pound of American cheese. We would then say that the real exchange rate is  pound of Swiss cheese per pound of American cheese. Notice that, like the nominal exchange rate, express the real exchange rate as units of the foreign item per unit of the domestic item. But in this instance, the item is a good rather than a currency.

Real and nominal exchange rates are closely related. To see how, consider an example. Suppose that bushel of American rice’ sells for \$100, and a bushel of Japanese nee sells for 16,000 yen. What is the real exchange rate between American and Japanese rice? To answer this question, we must first use the nominal exchange rate to convert the-prices into a common currency. If the nominal exchange rate is 80 yen pes dollar, then a price for American rice of \$100 per bushel is equivalent to 8,000 yen per bushel. American rice is half has expensive as Japanese rice. The real exchange rate is  bushel of Japanese rice per bushel of American rice.We can summarize this calculation for the real exchange rate with the following formula.

Thus, the real exchange rate depends on the nominal exchange rate and on the prices of goods In the two countries measured in the local currencies.

Why does the real exchange rate matter? As you snugness, the real exchange rate is a key determinant of how much a country exports and imports. When Uncle Ben  is deciding whether to buy U.S. rice or Japanese rice to put into its boxes, for example, it will hie rice is cheaper. The real exchange rate gives the answer. As another example, image that you are .ding whether to take .If a side vacation in Miami, Florida, or in Cancun, Mexico.

When studying an economy as a whole, macroeconomists focus on overall prices rather than the prices of individual items. That is, to measure the real exchange rate, they use price indexes, such as the consumer price index, which measure the price of a basket of goods and services. By using a price index for a US. basket (P), a price index for a foreign basket (P*), and the nominal exchange rate between the U.S. dollar and foreign currencies (e).We can compute the overall real exchange rate between the United States and other countries as follows.

Real exchange race (e x PVP)

As we examine more fully in the next chapter, a country’s real exchange rate is a key determinant of its net exports of goods and services. A depreciation (fall) in the US” real exchange rate means that U.S. goods have become cheaper relative to foreign goods. This change encourages consumers both at home and abroad to buy more US. goods and fewer goods from other countries. As ‘a result, U.S. exports rise, and US. imports fall, and both of these changes raise U.S. net exports, Conversely, an appreciation (rise)in the U.S. real exchange rate means that U.S. goods have become more expensive com pared to foreign goods, so U.S. net exports fall.

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