W1P6 The Real Exchange Rate

Question 1

Define the real exchange rate

Answer 1

The real exchange rate is the exchange rate in terms of goods and services. It is defined as:
σ = SP / P*
Where:
S=nominal exchange rate
P=domestic price level
P*=foreign price level
It is then important to define the domestic price level P and and the foreign price level P

Question 2

How do you define P and P* using the internal terms of trade?

Answer 2

Using the internal terms of trade, we assume that the domestic price level P is defined as the price of a basket of non-traded goods and the foreign price level P* is defined as the price of a basket of traded goods.

Thus:
σ = (S x Price of Non-Tradables) / Price of Tradables

Question 3

How do you define P and P* using the external terms of trade?

Answer 3

Using the external terms of trade, we assume that the domestic price level P is defined as the price of a basket of export goods and the foreign price level P*
is defined as the price of a basket of import goods

Thus:
σ = (S x Price of Export Goods) / Price of Import Goods

Question 4

What happens to the real exchange rate between two countries if the price level
at home doubles, all other things given?

Answer 4

when the price level at home doubles, all other things
equal, the real exchange rate doubles so that we have an appreciation

this would lead to more imports and less exports, so the current account worsens.

Question 5

What happens to the real exchange rate between two countries if the price of foreign goods doubles?

Answer 5

When the price of foreign goods doubles, then the real exchange rate
will depreciate. This would lead to less imports and more exports, so
the current account improves.

Question 6

What happens to the real exchange rate between two countries if the nominal exchange rate doubles?

Answer 6

When the nominal exchange rate doubles, the real exchange rate would
double as well i.e. it would appreciate when we use British terms.
Again, that would lead to more imports and less exports, so the current account worsens.

Question 7

In the course we use the primary account surplus
PCA = X − Z
To describe the current account balance. Which features of the overall current account balance does this miss?

Answer 7

It leaves out the income account balance i.e. income generated from interest, profits, and dividends of foreign investment.

Question 8

Describe and explain the Harrod-Balassa-Samuelson effect.

Answer 8

The Harrod-Balassa-Samuelson effect states that the price of non-tradable
goods is higher in rich countries than in poor countries because of the
higher productivity in rich countries. The haircut in Mumbai is more expensive than a similar haircut in London.

When a country becomes more productive in producing tradable products e.g. a car then wages in the tradable goods sector increase as the
marginal product of labour increases. Then, wages and hence the price
level in the non-tradable goods sector i.e. the price of a haircut needs
to increase as otherwise workers would go into the tradable goods sector where wages are higher. In the end, the wages in the tradable and
in the non-tradable sector have to equalise when labour is perfectly
mobile between sectors