Question

1. According to the theory of purchasing power parity:
   1. Can real exchange rates change? Explain (3 points)

2. What determines nominal exchange rates? Explain (3 points)

Answer 1

The real exchange rate (RER) seeks to measure the value of a country's goods relative to those of another country at the prevailing nominal exchange rate. It is defined as = Qt= St×Pt*/PT where PT* represents the price of foreign goods ,PT represents the price of domestic goods and St the nominal exchange rate .

If PPP holds therefore the real exchange rate Qt = 1, price of goods would remain same in the domestic country as in foreign country .But as FX spot rates tend to be overvalued or undervalued real exchange rate does not remains same ,it changes .

Qt<1 means that foreign currency is undervalued and Qt>1 means that foreign currency is overvalued.

B) Nominal exchange rate is the number of units if domestic currency that are needed to purchase a unit of foreign currency. It takes into account numerical value of the currencies.it doesn't take into account purchasing power of the currencies.

Every nominal exchange rate compares one individual currency against a basket if foreign currencies. The value of foreign currencies in a basket are weighted according to the value I'd trade with the domestic country .this could be export or import value etc.the weights often relate to the assets and liabilities of different countries.

A high Nominal exchange rates means the home country's currency is usually worth more than an imported currency .