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241

Real exchange rate

The rate at which a person can trade the goods and services of one country for the goods and services of another. The real exchange rate is a key determinant of bow much a country exports and imports.

242

Real exchange rate formula

= Nominal exchange rate (e) * domestic price (p) divided by foreign price (P')

243

Real exchange rate, appreciation and depreciation

A depreciation in the Australian real exchange rate means that Australian goods have become cheaper relative to foreign goods. Australian exports will rise, imports will fall and NX will increase.

An appreciation in the Australian real exchange rate means that Australian goods have become more expensive relative to foreign goods. Australian exports will fall, imports will rise and NX will decline

244

The current account

The current account measures the imbalance between a country's exports and imports in world markets for goods and services (NX) as well as the flow of net income (NY) and net transfers (NT)

CAB = NX + NY + NT

245

The capital and financial accounts

The capital and financial accounts measure an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners, that is NFI

CAB = NFI

This equation holds as every transaction that effects one side of the equation must affect the other side by the same amount.

246

Theory of purchasing power parity (PPP)

A theory of exchange rates in long-run whereby a unit of any given currency should be able to buy the same quantity of goods in all countries. The law of one price suggests that a good must sell for the same price in all locations. `

247

PPP and arbitage

If a good i sold for less in one location then another, a person could make a profit by buying the good in the location where it is cheaper and selling in in the location where it is more expensive. The process of taking advantage of differences in prices in different markets is called arbitrage

248

PPP and the nominal exchange rate

PPP means that the nominal exchange rate between the currencies of two countries will depend on the price levels in those countries

e = P/P*

If the central bank increases the supply of money in a country and raises the price level, it also causes the country's currency to depreciate relative to other currencies in the world.

249

Limitations of PPP

Tradeable goods are not perfect substitutes when they are produced in different countries

Many goods are not easily traded

Exchange rates do not always move to ensure that a dollar has the same real value in all countries