23. Y13 Exchange Rates

Question 1

What are the 2 ways an exchange rate can be measured?

Answer 1

Bi-lateral rates:
A bilateral rate is the rate of exchange of one currency for another, such as £1 exchanging for $1.50.

Multi-lateral rates:
A multilateral rate is the value of a currency against more than one other currency. Economists calculate multi-lateral rates to understand what is happening to the exchange rate, on average.

Question 2

What is NEER? (Nominal)

Answer 2

Nominal Effective Exchange Rate (NEER):
the exchange rate of one currency against a basket of currencies, weighted according to trade with each country (not adjusted for inflation)

Question 3

What is REER? (Real)

Answer 3

Real Effective Exchange Rate (REER):
the inflation adjusted exchange rate of one currency against a basket of currencies, weighted according to trade with each country.

Question 4

What is PPP?

Answer 4

PPP theory states that, in the long run, identical products and services in different countries should cost the same in different countries.

This is based on the belief that exchange rates will adjust to eliminate the short-term price differences.

Question 5

What is ‘Implied Value’?

Answer 5

This is what the amount in the foreign currency should be, assuming that the countries have purchasing power parity. At this exchange rate a Big Mac costs the same in both countries.

Question 6

What is ‘Market Value’?

Answer 6

Market Value - this is the converted amount according to the market exchange rates.

Question 7

Positives of PPP?

Answer 7

PPP rates reduce the risk of false international comparisons because of conclusions using observed market exchange rates.

It is a good tool to compare the economic performance and position of different countries.

It can help economists determine exchange rate trends in the long run, as exchange rates tend to move in the direction of the PPP exchange rate.

Purchasing power parity solves the problem of comparing countries with different standards of living.

Question 8

Negatives of PPP?

Answer 8

Import and Export Restrictions:
Restrictions such as quotas, tariffs and laws will make it difficult to buy goods in one market and sell them in another.

Travel Costs:
If it is very expensive to transport goods from one market to another, we would expect to see a difference in prices in the two markets.

Perishable Goods:
It may be simply physically impossible to transfer goods from one market to another. There may be a place which sells cheap sandwiches in London, but that doesn’t help me if I am living in Paris.

Location:
You cannot buy a piece of property in London and move it to Paris. Because of that property prices in markets can vary wildly. Since the price of land is not the same everywhere, we would expect this to have an impact on prices, as retailers in London may have higher expenses than retailers in Paris.