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Chapter 16 II part - Coggle Diagram
Chapter 16 II part
The Real Exchange Rate Approach to Exchange Rates
The real exchange rate (q) measures the relative price of domestic goods compared to foreign goods and reflects the rate of exchange for goods and services between countries.
It is defined using nominal exchange rates and price levels, and indicates how many domestic baskets are needed to purchase a foreign basket.
When relative PPP holds, the real exchange rate remains constant, and nominal exchange rate movements are fully offset by price level changes.
However, in the real exchange rate approach, nominal exchange rates are influenced not only by relative price levels (as in PPP), but also by changes in the real exchange rate.
Deviations from PPP arise when real variables, such as relative demand and supply, change.
Key Drivers of Real Exchange Rate Changes
Relative Demand Shifts:
A decrease in relative demand for domestic goods → real depreciation.
An increase in relative demand for domestic goods → real appreciation.
Relative Supply Shifts:
An increase in relative supply (e.g., higher productivity) → real depreciation.
A decrease in relative supply → real appreciation.
This framework allows nominal exchange rates to respond to both monetary factors (like money supply) and real factors (like productivity and demand), making it a more complete model than one based solely on PPP.
Figure: Determination of the Long-Run Real Exchange Rate
An increase in the relative supply of U.S. goods (e.g., due to productivity gains) lowers domestic prices. As a result, the real exchange rate increases, meaning U.S. goods become cheaper relative to foreign goods.
This positive relationship exists because cheaper domestic goods raise demand for them, while foreign goods become relatively more expensive.
At full employment, the relative supply curve is vertical, meaning output cannot increase further in response to demand shifts.
In such a scenario, changes in demand affect prices rather than quantities, so relative supply has limited influence on the exchange rate.
The Role of Inflation and Expectations
Long-Run Model Without PPP (Short-run price rigidity causes exchange rate overshooting)
A change in money supply → change in average price level (in the long run).
No permanent inflation in the long run; inflation occurs only during the transition.
During this transition:
Inflation raises nominal interest rates to their long-run value.
Expectations of higher inflation → higher expected return on foreign deposits → domestic currency depreciates.
Prices adjust slowly ⇒ exchange rate overshoots
Initial depreciation exceeds the long-run depreciation.
Over time, as prices adjust, the exchange rate appreciates to its long-run level.
Monetary Approach (with PPP) (Price levels adjust with expectations ⇒ no overshooting, just immediate depreciation)
A permanent increase in money supply growth → permanent inflation.
Higher inflation → permanently higher nominal interest rate (via Fisher effect).
Expectations of inflation:
Lower expected purchasing power of domestic currency relative to foreign currency.
Leads to domestic currency depreciation.
No overshooting occurs because:
The exchange rate adjusts smoothly to reflect changes in prices and expectations.
Prices adjust immediately with inflation expectations.