Question

9 What is real exchange rate? Show how real exchange rate depreciation of a country's currency can promote CA surplus?

Answer 1

The real exchange rate tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country. The real exchange rate is represented by the following equation:
Real exchange rate (R) = (Nominal exchange rate x Price of the foreign basket) / (Price of the domestic basket)

Formally it can be written as:

R=(E.P*)/P

where the foreign price level is denoted as P* ,

the domestic price level as P

And the nominal exchange rate is defined as E

(Nominal exchange rate is the number of units of the domestic currency that can purchase a unit of a given foreign currency.)

Example - Suppose that the dollar–euro exchange rate is $1.42 per euro, PE (the price of the Euro-zone’s consumption basket) is €100, and PUS(the price of the U.S. consumption basket) is $142. In this case, the real exchange rate is 1.

A decrease in R is termed appreciation of the real exchange rate, an increase is termed depreciation.

Real exchange rate depreciation of a country's currency can promote CA surplus.

Current Account balance can be defined as the demand for a country's export less that country's own demand for imports.

Formally,

Current Account (CA) = Exports (EX) - Import (IM)

Real exchange rate changes affect the current account because they reflect changes in the price of domestic goods and services relative to foreign goods and services.

When real exchange rate depreciate (i.e. value of real exchange rate rises) , for example , foreign products become more expensive relative to domestic products. Foreign consumers will respond to this price shift ( a real domestic currency depreciation) by demanding more of home country's export. This response by foreigners will therefore raise EX and improve the domestic country's Current account.

So more exports means more CA surplus