Topic 8 - Nominal and Real Exchange Rates

Question 1

Where does the demand for NZ$ come from?

Answer 1

Exports. When a business here supplies goods overseas, the buyer has to first buy NZ$ to pay for the goods. This increases demand for NZ$.

Question 2

Where does the supply of NZ$ come from?

Answer 2

Imports. When someone buys a good from overseas, they have to provide NZ$ in exchange for the other nations money. This increases the supply of NZ$.

Question 3

What is the Nominal Exchange rate?

Answer 3

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

Question 4

How is the nominal exchange rate expressed?

Answer 4

1. In units of foreign currency per one NZ$,

2. In units of NZ$ per unit of the foreign currency.

Question 5

What factors will change the value of the NZD?

Answer 5

1. Relative interest rates.
2. Imports/Exports.
3. Relative inflation rates.
4. Relative prosperity of our trading partners.

Question 6

How do domestic interest rates affect the demand curve for foreign currency?

Answer 6

A high relative interest rate in NZ vs the rest of the world, will increase the demand for the NZ currency. This will increase the value of the NZ dollar.

Question 7

How do foreign interest rates affect the demand curve for foreign currency?

Answer 7

A low relative interest rate in NZ vs the rest of the world, will decrease the demand for the NZ currency. This will reduce the value of the NZ dollar.

Question 8

What effect will the exchange rate have on imports and exports?

Answer 8

If the value of the NZD appreciates then our exports become less competitive and our imports become more competitive, and vice versa.

Question 9

What is the “real” exchange rate?

Answer 9

The real exchange rate is the rate at which a person can trade the goods/services of one country for the goods/services of another.

Question 10

What is the real exchange rate based on?

Answer 10

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

Question 11

True/False: The real exchange rate is a key determinant of how much a country exports and imports.

Answer 11

True.

Question 12

How is the real exchange rate calculated?

Answer 12

real exchange rate = ( nominal exchange rate x domestic price ) / foreign price.

Question 13

How does the relative prosperity of our trading partners affect the value of the NZD?

Answer 13

As our trading partners become richer they are more likely to buy our products and at a higher price, which will increase the value of the NZD.

Question 14

How does the relative rates of inflation affect the value of the NZD?

Answer 14

If a country has high inflation it will reduce the value of its currency.

Question 15

Define: Purchasing Power Parity.

Answer 15

One unit of any given currency is able to buy the same quantity of goods in all countries. AKA Law of one price.

Question 16

What is arbitrage?

Answer 16

Arbitrage is the process of taking advantage of differences in prices in different markets. For example buying a good in a country where the price is low, and selling it in a country where the good is high.

Question 17

How does arbitrage lead to purchasing power parity?

Answer 17

If someone buys goods in one country and sells them in another. The prices will increase in the country being bought from, and fall in the country being sold to.

Question 18

What are the limits of purchasing power parity?

Answer 18

1. Some goods are not easily traded or shipped from one country to another (e.g. services).
2. Tradable goods are not always perfect substitutes when they are produced in different countries.