I think I have discovered (thanks to several students who pointed it out to me yesterday) the source of the confusion that is causing you a lot of consternation. The problem lies in the notation of the real exchange rate. Specifically, it seems that the text book and the study guide use a notation that is different from the one I was using in my slides. If this is the case, then – for the sake of consistency – I will go with what’s in the book.
To that end, I’ve edited the necessary slides in Lecture #5. I’ve also written up a short handout and using an example of a European price increase, illustrated how we get to what is “foreign” and what is “home” when it comes to calculating the real exchange rate from the nominal exchange rate. Please see the ‘Handouts’ section on the right.
For the sake of the exam, I think it’s important for you to qualitatively understand what happens where, and which currency becomes more expensive and less expensive, rather than focusing specifically on what is “home” and what is “foreign.” Nevertheless, if this is something that’s in your head, nagging you, as it has been for me, then read my write-up.
I also dredged up a handout that’s written by an IMF economist (Luis A. V. Catão) about the basics of the real exchange rate and purchasing power parity (PPP). We’ll soon be talking about PPP, so it won’t hurt to take a look at what Catão has written up. He starts by questioning: How do we value a currency?
George Soros had the answer once—in 1992—when he successfully bet $1 billion against the pound sterling, in what turned out to be the beginning of a new era in large-scale currency speculation. Under assault by Soros and other speculators, who believed that the pound was overvalued, the British currency crashed, in turn forcing the United Kingdom’s dramatic exit from the European Exchange Rate Mechanism (ERM), the precursor to the common European currency, the euro, to which it never returned.
This is, of course, not the best way to value a currency, but certainly a great way to make a point (so long as you have $1b to make bets against currencies). So Catão introduces a RER index which he calls the real effective exchange rate or the REER, which is defined as follows:
The REER is an average of the bilateral RERs between the country and each of its trading partners, weighted by the respective trade shares of each partner. Being an average, a country’s REER may be in “equilibrium” (display no overall misalignment) when its currency is overvalued relative to that of one or more trading partners so long as it is undervalued relative to others.
This is one way to measure whether purchasing power parity exists, and if it doesn’t, the direction that the nominal rates will move to adjust towards it. It’s important to remember that, as long as markets are free, nominal rates will move towards purchasing power parity. This goes back to the example of Kenyan coffee that I had talked about in class. If coffee is cheaper in real terms in Kenya than it is in the US, ignoring transportation and other costs, people (or arbitrageurs) will buy coffee en masse from Kenya and sell it in the US, driving coffee prices up in Kenya, and down in the US, so that PPP will ultimately exist between Kenyan coffee and US coffee .
This also forces us to think about the real exchange rate not just as the nominal rate without inflation, but as a measure of PPP. More on this when we get to revisit exchange rates in our flexible-price model. At that point, we can also take a look at The Economist‘s Big Mac Index.
While this is all fun stuff, I don’t know about you, but I suddenly feel like having a burger and some coffee…