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Economics: Real Exchange Rates

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About this Lesson

  • Type: Video Tutorial
  • Length: 6:12
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 66 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: International Focus (25 lessons, $43.56)
Economics: Exchange Rates (6 lessons, $12.87)

In this video lesson on economics, you'll learn about real exchange rates. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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We have defined the Nominal Exchange Rate as the amount of foreign currency you can buy with a unit of domestic currency. Suppose you are U.S. national. Then your exchange rate between U.S. and Mexico might be 10 Mexican pesos per U.S. dollar. The nominal exchange rate is 10 pesos per dollar. You are going to care about this Nominal Exchange Rate if you are buying goods and services in Mexico. Let's take an example and see how this works.
Suppose you are considering buying oranges and you are trying to decide whether you want to buy them in the U.S. or Mexico. And suppose the following numbers hold in this example, that is, the nominal exchange rate is 10 pesos to the U.S. dollar and an orange in the U.S. costs 1 U.S. dollar. Let's suppose also that an orange in Mexico costs 5 pesos that means that for 10 Mexican pesos you can afford to buy 2 Mexican oranges. Now think about how this works. Are you going to spend a dollar on an orange in the U.S. or are you going to take your dollar convert it into 10 Mexican pesos and buy 2 oranges from Mexico? In this particular case, buying from Mexico looks like a better deal. You can see the advantage of buying in Mexico when you look at a measure we call the real exchange rate. Just as the Nominal Exchange Rate converts one money quantity into another, the Real Exchange Rate converts one real quantity of goods and services into another. It tells the real exchange rate or the goods and services exchange rate between the U.S. and Mexico. Let's look at how it's calculated.
The Real Exchange Rate is simply the Nominal Exchange Rate multiplied by the ratio between the Domestic Price Level and the price level in another country. The formula is written this way. The Real Exchange Rate is equal to the Nominal Exchange Rate multiplied by the Domestic Price Level divided by the Foreign Price Level. Let's take a simple case where the only good involved is oranges, oranges in the U.S. and oranges in Mexico and the dollar-peso nominal exchange rate. Here is how we calculate the real exchange rate in that case. We would notice that our nominal exchange rate is going to be written as pesos to the dollar, in our simple case 10 pesos to the dollar. We are going to multiply that by the price level in the U.S. In this particular case it's going to be the price per orange, dollars per orange, in our example $1 per orange in the U.S. Then we will divide that quantity by the amount of pesos you have to pay to get a Mexican orange that is the price level in Mexico when oranges are the only good.
Notice how much cancels here. Pesos in the numerator cancel with pesos in the denominator. Dollars in this numerator cancel with dollars in this denominator. And we are ultimately left with U.S. oranges in the denominator and Mexican oranges in the denominator of the denominator inverted to give us a quantity of Mexican oranges per U.S. orange. How many Mexican oranges can we get per U.S. orange? Well if the nominal exchange rate is 10 pesos to the dollar and oranges are $1 in the U.S., then the Peso price of an orange purchased in the U.S. is 10 pesos. Divide that by 5 pesos per Mexican orange and you calculate then that you can buy 2 Mexican oranges for the same money that you can get 1 U.S. orange. The Real Exchange Rate is 2 Mexican oranges per U.S. orange.
Now when you got a real exchange rate of 2 you have got an unstable situation. That is, if there are no trade barriers and no transportation cost, there is no reason why anyone would buy 1 orange in the U.S. when they can get 2 oranges, the exact same product, doubled in Mexico. What we would expect to happen in this case is that the demand for U.S. oranges would fall, the demand for Mexican oranges would rise, and there would start to be adjustments. First of all these prices would begin to rise, so instead of 5 pesos per orange they might be 6 or 7 or 10. Instead of being a dollar per orange we might see the price falling towards 75 cents or 50 cents per orange. Also, since trade is moving in this direction, a lot of people are going to want to trade dollars for pesos and we might see the U.S. dollar depreciate. Instead of buying 10 pesos it might only buy 7 or 6 or 5. Let's suppose for the moment that all of the adjustment takes place in terms of the exchange rate. What exchange rate would make U.S. oranges trade for Mexican oranges at a rate of 1 to 1? That is, what nominal exchange rate would give us a real exchange rate of 1? In this particular case the answer is going to be $1 trading for 5 Mexican pesos. If the dollar depreciates to the point where $1 buys 5 Mexican pesos, then these numbers govern our example. In this particular case you can take a U.S. orange, trade it in the market for $1, trade that dollar in the foreign exchange market for 5 Mexican pesos, and spend those 5 pesos on 1 Mexican orange. 1 to 1 trade, the Real Exchange Rate is now equal to 1 and that's a stable situation. It's what we call the law of one price. Eventually it should cost the same whether you buy the good at home or whether you trade your money for a foreign currency and buy the good abroad.
Once again, the law of one price assumes no trade barriers, no transportation costs, or any other interference with free and costless trade. The real exchange rate tells you whether the law of one price is holding or not. And if the real exchange rate is not equal to one for a particular good, there is the opportunity to prices or the exchange rate to adjust to bring things to equality.
International Focus
Exchange Rates
Real Exchange Rates Page [1 of 1]

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