Question

Suppose as a result of a sudden and unexpected change in trade policy, the real exchange rate of the US dollar relative to the British pound appreciates by 10%. Write down the equation relating nominal exchange rates to real exchange rates. Explain how you expect the nominal exchange rate to behave over the short run and why. How does your answer change for the long run?

Answer 1

There is a difference between real exchange rate and nominal exchange rate.

While real exchange rate tells you, how much goods and services we need to sacrifice( domestic); to exchange the foreign goods and services.

But nominal exchange rate is the rate at which, foreign currency can be exchanged with respect to the domestic currency.

Real exchange rate = (nominal exchange rate * domestic price)/ foreign price.

So percentage change in real exchange rate = percentage change in nominal exchange rate + ( difference between the price of two countries) .

When real exchange rate appreciates by 10% then the value of US dollar will increase to pound by 10%. . So in the short run, the nominal exchange rate will rise.

But in the long run, the differences of prices will change. Appreciation reduces the inflation, so the difference between prices, may be offset by the change in real exchange rate. So the nominal exchange rate will be unaffected by the change in real exchange rate.