In this video we will introduce the definition of the exchange rate and explore how it is measured.
Per the CIE syllabus we will consider the nominal, real and trade-weighted exchange
rates.
The definition you should be aware of is that the exchange rate is the rate at which one
currency is exchanged for another.
The board you see on the right is the one you’ve probably encountered at an airport
currency conversion counter.
Rates published here are examples of the nominal exchange rate.
To explain the real exchange rate I’ll quote from the IMF website referenced below:
“One can measure the real exchange rate between two countries in terms of a single
representative good—say, the Big Mac, the McDonald's sandwich of which a virtually identical
version is sold in many countries.
If the real exchange rate is 1, the burger would cost the same in the United States as
in, say, Germany, when the price is expressed in a common currency.
That would be the case if the Big Mac costs $1.36 in the United States and 1 euro in Germany.
In this one-product world (in which the prices equal the exchange rates), the purchasing
power parity (PPP) of the dollar and the euro is the same and the RER is 1 (see box).
In this case, economists say that absolute PPP holds.
But suppose the burger sells for 1.2 euros in Germany.
That would mean it costs 20 percent more in the euro area, suggesting that the euro is
20 percent overvalued relative to the dollar.
If the real exchange rate is out of whack, as it is when the cost is 1.2, there will
be pressure on the nominal exchange rate to adjust, because the same good can be purchased
more cheaply in one country than in the other.
It would make economic sense to buy dollars, use them to buy Big Macs in the United States
at the equivalent of 1 euro, and sell them in Germany for 1.2 euros.
Taking advantage of such price differentials is called arbitrage.
As arbitrageurs buy dollars to purchase Big Macs to sell in Germany, demand for dollars
will rise, as will its nominal exchange rate, until the price in Germany and the United
States is the same—the RER returns to 1.
In the real world, there are many costs that get in the way of a straight price comparison—such
as transportation costs and trade barriers.
But the fundamental notion is that when RERs diverge, the currencies face pressure to change.
For overvalued currencies, the pressure is to depreciate; for undervalued currencies,
to appreciate.
It can get more complicated if factors such as government policies hinder normal equilibration
of exchange rates, often an issue in trade disputes.”
For further reading on the real exchange rate, follow the IMF link in the video notes below
to open a short two page summary on real exchange rates which provides good information for
both students and teachers to use.
Some of you may have discussed the Big Mac Index in your economics classes to compare
the real value of currencies relative to the US dollar.
In this image we can see that $100 buys about 23 Big Macs in the US.
This chart from the Economist shows you how many Big Macs $100 buys in the respective
countries (using 2012 dollars).
If you can buy more than 23 Big Macs, such as in China and Mexico, it is assumed the
currency is undervalued and will tend to appreciate in the long run.
If it buys less than 23 Big Macs, such as in countries like Australia and Denmark, it
is assumed that the currency is overvalued and will tends to depreciate in the long run.
The trade weighted exchange rate is a weighted average of exchange rates of the domestic
currency versus foreign currencies.
The weight for each foreign country is set by its share in trade.
To illustrate, let’s look at a past multiple choice question from the CIE winter 2013 paper.
Country X trades with only two countries, the USA and Japan.
90% of the country’s trade is with the USA and 10% is with Japan.
The original value of the trade-weighted exchange rate index is 100.
The value of country X’s currency against the US$ rises by 10%.
The value of country X’s currency against the Japanese yen rises by 50%.
What will be the value of country X’s new trade-weighted exchange rate index?
While this problem looks tricky, it is quite easy to solve when we break it down.
To calculate the trade weighted exchange rate we simply increase the basket from 100 to
110 and multiply by 90 to value the impact of the change against the American currency.
We then appreciate the basket from 100 to 150 and multiply by 10 to value the impact
of the change against the Japanese currency.
We add these two figures together and divide this sum by 100 to get to our answer of 114.
That wraps ups this introduction to the exchange rate and I hope it helps you develop your
understanding.
If you have any questions, please feel free to leave them below or email me at enhancetuition@gmail.com.
You can also tweet me @enhancetuition and visit me soon on www.enhancetuition.co.uk.
I’ll be posting a video once the website is live.
As always, thanks for watching and I will see you in the next one!