Topic 8 Nominal and real exchange rates

Topic 8: Nominal and Real Exchange Rates

1. Learning Objectives

  • Apply the concept of supply and demand in the market for currency.

  • Explain the relationship between the exchange rate and the quantity of currency demanded and supplied.

  • Describe the difference between and calculate nominal and real exchange rates.

  • Understand the concept of purchasing power parity (PPP).

  • Analyze how exchange rates affect international trade.

2. Understanding Exchange Rates

2.1 Definition

  • The exchange rate is the rate at which one currency is traded for another in the currency market (e.g., 0.54 EUR = 1 NZD, 0.59 USD = 1 NZD, 0.9 AUD = 1NZD).

2.2 Determinants of Exchange Rates

  • Determined by the interaction of supply and demand for currencies (demand = MB, supply = MC):

    • Demand for currency is downward sloping at higher exchange rates.

    • Supply for currency is upward sloping at higher exchange rates.

  • Equilibrium in the currency market establishes the exchange rate.

3. Supply and Demand in Currency Markets

3.1 Demand Side

  • Demand for Currency: Benefits include purchasing goods and services, investing in local capital, earning interest in the local economy.

    • Increased demand for NZ goods & services shifts demand to the right.

    • Higher interest rates in NZ attract foreign currency, boosting demand.

3.2 Supply Side

  • Supply of Currency: Consideration includes the opportunity to hold or sell currency.

    • Factors impacting supply: inflation, instability, and access to other markets.

    • Sellers might opt for other currencies depending on their preferences and global demand.

4. Types of Exchange Rates

4.1 Nominal Exchange Rate

  • Defined as the rate at which one currency can be exchanged for another.

  • Example: NZD$1 = £0.47 or NZD$2.11 = £1. e = # of pounds per dollar then e = 0.47£/$1 = 0.47£/$

  • If the nominal exchange rate increases, the currency appreciates; if it decreases, it depreciates.

4.2 Real Exchange Rate

  • Expresses the rate at which one can trade goods and services between countries.

  • Key formula: Real Exchange Rate = (Nominal Exchange Rate) x (Domestic Price Level / Foreign Price Level).

  • The real exchange rate reflects changes in price levels across countries and impacts export and import levels.

5. Purchasing Power Parity (PPP)

5.1 Concept

  • PPP suggests that in the long run, exchange rates should adjust so that identical goods cost the same in different countries.

  • The law of one price supports the idea that goods must sell for the same price across different locations to prevent arbitrage opportunities.

5.2 Limitations of PPP

  • Non-tradable goods: Many services and products cannot be easily transported.

  • Imperfect substitutes: Similar goods in different countries may not be identical (e.g., lamb from NZ vs. US).

6. Case Studies and Practical Examples

6.1 Hyperinflation in Zimbabwe

  • The case illustrates the limits of PPP when economic conditions lead to extreme currency fluctuations.

  • Currency values were set to zero leading to multiple currencies being used in the economy.

7. Summary Points

  • Nominal exchange rates reflect the relative price of currencies, while real exchange rates reflect the relative price of goods/services.

  • Changes in nominal rates affect currency strength, impacting trade dynamics.

  • Understanding PPP helps analyze exchange rate stability in the global market.