What happens when real exchange rate increases?
An increase in a nation's REER is an indication that its exports are becoming more expensive and its imports are becoming cheaper. It is losing its trade competitiveness.
An increase in REER implies that exports become more expensive and imports become cheaper; therefore, an increase indicates a loss in trade competitiveness. REER data may be accessed through the International Financial Statistics (IFS) dataset portal here.
In the goods market, a positive shock to the exchange rate of the domestic currency (an unexpected appreciation) will make exports more expensive and imports less expensive. As a result, the competition from foreign markets will decrease the demand for domestic products, decreasing domestic output and price.
A higher U.S. real interest rate increases the attrac- tiveness of U.S. assets, leading to an increase in the demand for dollar-denominated assets and an appreciation of the real exchange rate.
If there was PPP, then the real exchange rate would be equal to 1. If it is greater than 1, then the foreign currency is overvalued relative to the domestic currency (and, of course, the domestic currency is undervalued.) If it is less than 1, the foreign currency is undervalued relative to the domestic currency.
A decrease in R is termed appreciation of the real exchange rate, an increase is termed depreciation. The real rate tells us how many times more or less goods and services can be purchased abroad (after conversion into a foreign currency) than in the domestic market for a given amount.
How Does a Higher Exchange Rate Affect Trade? When a country's exchange rate increases relative to another country's, the price of its goods and services increases. Imports become cheaper. Ultimately, this can decrease that country's exports and increase imports.
Aggregate Demand can increase or decrease depending on several things. In effect, these things will cause shifts up or down in the AD curve. These include: Exchange Rates: When a country's exchange rate increases, then net exports will decrease and aggregate expenditure will go down at all prices.
The exchange rate gives the relative value of one currency against another currency. An exchange rate GBP/USD of two, for example, indicates that one pound will buy two U.S. dollars. The U.S. dollar is the most commonly used reference currency, which means other currencies are usually quoted against the U.S. dollar.
The increase in prices causes exports to fall. This results in a fall in the exchange rate.
What does the real exchange rate depend on?
The real exchange rate (RER) between two currencies is the nominal exchange rate (e) multiplied by the ratio of prices between the two countries, P/P*. The RER therefore is eP*/P. Consider the case of Germany relative to the United States.
Three effects of the rise of the real exchange rate (or of its appreciation) on the economic growth are positive (work effort, capital/labour ratio, education level), while the five (exports, foreign direct investments, employment, relative importance of industrial production and of state- owned enterprises) are ...
Overview of Exchange Rates
A lower-valued currency makes a country's imports more expensive and its exports less expensive in foreign markets. A higher exchange rate can be expected to worsen a country's balance of trade, while a lower exchange rate can be expected to improve it.
The more recent equilibrium theory of the type advanced by Helpman and Razin (1982) and Lucas (1982) suggests the answer that real shocks cause nominal and real exchange rates to move together, as the outcome of equilibrating forces.
The real exchange rate is an important concept in economics. It is a broad summary measure of the prices of one country's goods and services relative to those of another country or group of countries, and is thus an important consideration when analysing macroeconomic conditions in open economies.
The real exchange rate is related to net exporters. When the real exchange rate is lower, domestic goods are less expensive relative to foreign goods and net exports are greater. The trade balance (net exports) must equal the net capital outflow (which is savings minus investment).
When an exchange rate changes, the value of one currency will go up while the value of the other currency will go down. When the value of a currency increases, it is said to have appreciated. On the other hand, when the value of a currency decreases, it is said to have depreciated.
If exchange rates go down, the value of the currency will decrease, exports will increase and imports will decline. This is due to the fact that when the value of currency depreciates, the goods produced there are cheaper; thus, it is more expensive to import goods.
Exchange rates affect aggregate demand through their effects on exports and imports. Specifically, it affects the relative prices of imported or exported goods and, ultimately, their competitiveness and demand.
Changes in exchange rates
Overall, this will cause a decrease in short run aggregate supply.
How does real interest rate affect long run aggregate supply?
The higher interest rates will lower investment spending and hence the capital stock. A lower capital stock leads to a decrease in long-run aggregate supply.
A strong exchange rate is when the value of a currency is high relative to other currencies. This makes a country's exports more expensive and its imports less expensive. As a result, demand for the country's exports will typically decrease and demand for its imports will typically increase.
If the German price is 2.5 euros and the U.S. price is $3.40, then (1.36) X (2.5) ÷ 3.40 yields an RER of 1. But if the German price were 3 euros and the U.S. price $3.40, the RER would be 1.36 X 3 ÷ 3.40, for an RER of 1.2.
The real effective exchange rate (REER) is the weighted average of a country's currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country's currency against each country within the index.
1. Kuwaiti dinar. Known as the strongest currency in the world, the Kuwaiti dinar or KWD was introduced in 1960 and was initially equivalent to one pound sterling. Kuwait is a small country that is nestled between Iraq and Saudi Arabia whose wealth has been driven largely by its large global exports of oil.
