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Nominal and real exchange rates
Two types of exchange rate exist:
The nominal exchange rate (e): The rate at which you can convert between the currencies of two countries. For example, 1.5$/£ (that is, $1.50 per £) is a nominal exchange rate. This is usually the rate that you see quoted in the news or in bureau de change.
The real exchange rate ( ): The rate at which you can convert between the goods of two countries.
The real exchange rate is defined as:
Here, P is the domestic price level and P* is the price level abroad. If the real exchange between the UK and the US is equal to 1, a certain amount of pounds buys you just as much in the UK as it would if you were to exchange those pounds for dollars and spend them in the US. If the real exchange rate is equal to 2, you can buy twice as much in the US as in the UK with the equivalent amount of money.
In the short run, macroeconomists think that prices are ‘sticky’ and don’t change very much. This means that the nominal exchange rate and the real exchange rate move together. Thus when the exchange rate
depreciates (nominal or real), you expect net exports to rise.
Real exchange rate and purchasing power parity
Recall that net exports (NX) is a component of aggregate demand. The real exchange rate has an impact on the level of net exports and therefore on AD also.
In the long run, economists think that the real exchange rate is what really matters. People don’t care about how much foreign currency they can buy per se: instead, they want to know how much they can buy with their foreign currency in goods. All other things being equal, if a country’s goods are relatively cheaper than other countries’ goods, it’s likely to run a trade surplus. If it’s more expensive, that country is likely to run a trade deficit.
When the real exchange rate between two countries is equal to 1, goods can be exchanged one-for-one. That is, whether you buy in your home country or whether you convert your currency and buy abroad, you can purchase exactly
the same amount of goods. For this reason is called the case of purchasing power parity (PPP).
If free trade exists between two countries (that is, goods can be traded between them with few restrictions), an economic force called arbitrage acts to ensure that the real exchange rate doesn’t stray too far from PPP ( ).
An arbitrage opportunity arises when the same item is available for sale at two different prices. An enterprising individual can buy the item at the low-price location and then sell the item at the high-price location, locking in the difference as profit. Doing so increases demand at the low-price location and increases supply at the high-price location, which increases the lower price and decreases the higher price. The arbitrageur (the person engaging in arbitrage) can continue to make a profit until the two prices become equal.
You can apply the same idea to two different countries: if the same goods cost a lot less in one country than another, individuals can buy something from the cheaper country and sell it in the more expensive country. By doing
so, they increase the price in the former and decrease the price in the latter.
Of course, a number of reasons exist why arbitrageurs can’t perfectly close the gap between prices in two countries:
Not all goods are tradable: Many goods just can’t be traded. Haircuts for example are much cheaper in some countries than in others. But you can’t buy a haircut in one country and export it to another!
Lack of free trade: Despite the best efforts of economists, most countries still don’t trade freely with the rest of the world. Even in the UK, a relatively open economy, restrictions apply to importing goods.
Transportation costs: Even if arbitraging between two countries is possible, the transportation costs may make it prohibitively expensive. This means that only sufficiently large departures from PPP can be arbitraged effectively.
For these and other reasons, deviations from PPP can and do persist. Nonetheless, economists still think that the possibility of arbitrage ensures that exchange rates don’t deviate too far from PPP. So, the real exchange rate has a big impact on the level of net exports because it determines the terms that countries trade with one another. This in turn impacts aggregate demand because NX is a component of AD. And finally, in the long run, the real exchange rate shouldn’t deviate too far from PPP because of the possibilities for arbitrage.
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