Exchange Rates

• The exchange rate between two countries is the price at which residents of those countries trade with each other.

• The nominal exchange rate is the relative price of the currency of two countries.

• For example, if the exchange rate between Bangladeshi taka and Us dollar is 80 taka per dollar, then one can exchange 80 taka for one dollar in world markets for foreign currency.

• Real exchange rate is the relative price of the goods of two countries.

• That is, the RER tells us the rate at which we can trade the goods of one country for the goods of another.

• To see the relation between RER and NER, consider a single good produced in many countries: cars.

• Suppose a Bangladeshi car costs Tk. 16000 and a similar American car costs $400.

• To compare the prices of two cars, we must convert them into a common currency. If one dollar is worth 80 Taka, then one taka equals .0125 dollar.

• Then a Bangladeshi car is worth .0125*16000=$200.

• Therefore a Bangladeshi car costs one-half of what an American car costs.

• In other words, at current prices, we can exchange two Bangladeshi cars for one American car.

• We can summarize our calculation as follows:• RER=[(.0125/Taka)*(16,000 taka/Bangladeshi

Car)]/(400 dollars/American car)• At these prices and this exchange rate we

obtain one-half of an American car per Bangladeshi car.

• We can write this calculation as:• RER=[NER* Price of Domestic good]/Price of• Foreign good• The rate at which we exchange foreign and

domestic goods depends on the prices of the goods in the local currencies and on the rate at which the currencies are exchanged.

• On the basis of this calculation, we can define the RER for a broader basket of goods:

• RER= NER* Ratio of price levels• E=e * P/P*• This shows that RER between two countries is

computed from the NER and the price levels in two countries. If RER is high, foreign goods are relatively cheap and domestic goods are relatively expensive and vice versa.