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Real Exchange Rate

Real Exchange Rate. RER = e × (P/Pf) For example, the India VS Australia case Nominal exchange rate e = 50 Rupee/$ Price of a shirt 250 Rupees in India 10 dollars in Australia Are you better off buying in India or in the Australia? . RER = e × (P/Pf)

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Real Exchange Rate

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  1. Real Exchange Rate • RER = e × (P/Pf) • For example, the India VS Australia case • Nominal exchange rate e = 50 Rupee/$ • Price of a shirt • 250 Rupees in India • 10 dollars in Australia • Are you better off buying in India or in the Australia?

  2. RER = e × (P/Pf) = 50 Rs/$ × ($10/Rs250) = 2 Indian shirts/1 AU shirt • So shirts are in real terms, twice as expensive in the AU as they are in India

  3. Overvalued exchange rate • An overvalued exchange rate is a situation when an exchange rate is higher that its fundamental value. • Usually occurs in the fixed exchange rate system.

  4. In a situation of an overvalued exchange rate a government can: • devalue its nominal fixed exchange rate; bringing the official value into line with its fundamental value • restrict international transactions; • buy back its currency in foreign exchange market, in other words, the gov’t becomes the demander of its own currency in the forex market (The most widely used approach).

  5. To support the domestic currency the central bank must use the reserves that correspond to the country’s balance of payment deficit. • It cannot do that forever because the amount of reserves is limited.

  6. S A B Official value 0.70 £/$ Fundamental value 0.65 £/$ D Q of $ At official exchange rate of 0.70 £/$ is above the fundamental/market value; The $ (against £) is overvalued Excess supply of $ in the foreign exchange market: the length of AB To keep the official exchange rate from falling down, the gov’t could purchase a quantity of $ with £ in foreign exchange market equal to length of AB.

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