Reading 17: The Exchange Rate and the Balance of Payments-LOS class, 2011, center, between, exchange

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Session 4: Economics for Valuation
Reading 17: The Exchange Rate and the Balance of Payments

LOS a: Define an exchange rate, and differentiate between the nominal exchange rate and the real exchange rate.

 

 

Assuming no changes in the prices of a representative consumption basket in two currency areas over the measurement period, changes in the nominal exchange rate:

A) can be extrapolated to calculate interest rates.

B) can be converted to the real exchange rate using interest rates.

C) are equal to changes in the real exchange rate.

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The real interest rate = the nominal interest rate × ratio of consumption basket (or index) price levels in both countries. Assuming no price changes, the real exchange rate has remained the same as the nominal interest rate during the period.

You can think of the ratio of the consumption basket (or index) price levels in two countries as the bracketed portion of the Fisher relation for two countries. Here is the Fisher relation for two countries:

Here is the ratio of the consumption basket (or index) price levels in two countries:

If inflation in A is 10% and inflation in B is 0%, the ratio of consumption basket (or index) price levels is 1.1. If inflation in both countries is 0%, the ratio of consumption basket (or index) price levels is 1 and the nominal interest rate = the real interest rate. If the nominal interest rate = the real interest rate, changes in the nominal exchange rate = changes in the real exchange rate.

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In the currency market, traders quote the:

A) base currency rate.

B) nominal exchange rate.

C) real exchange rate.

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The nominal exchange rate is quite simply the price of one currency relative to another. It is the quote observed in currency markets.