Can someone help explain this? I dont understand the explanation, so any clarification would be appreciated. Further, how does an increase in real interest rate indicate the purchase power increase? From kaplan’s book – I look at the equation on real exchange rate= nominal + base/price.
One year ago, the nominal exchange rate for USD/EUR was 1.300. Since then, the real exchange rate has increased by 3%. This most likely implies that:
A) the nominal exchange rate is less than USD/EUR 1.235.
the purchasing power of the euro has increased approximately 3% in terms of U.S. goods.
inflation in the euro zone was approximately 3% higher than inflation in the United States.
An increase in the real exchange rate USD/EUR (the number of USD per one EUR) means a euro is worth more in purchasing power (real) terms in the United States. Changes in a real exchange rate depend on the change in the nominal exchange rate relative to the difference in inflation. By itself, a real exchange rate does not indicate the directions or degrees of change in either the nominal exchange rate or the inflation difference. (LOS 18.a)
Real exchange rates take into account of effects of inflation, so it is a measure of what you can actually buy (i.e. purchasing power). So in this case, say 1 USD = 1 EUR at first, then if real exchange rates increase USD/EUR, it means 1 EUR can buy 3% more USD, i.e. purchasing power increases for EUR.
So when looking at the equation:
USDreal = USDnom / CPI-USD , where CPI represents consumer price index (a measure of inflation)
EURreal = EURnom / CPI-EUR
Thus, the real exchange rate (USDreal / EURreal) relates to the nominal exchange rate (USDnom / EURnom) by:
USDreal / EURreal = (USDnom / CPI-USD) / (EURnom / CPI-EUR)
= (USDnom / CPI-USD) × (CPI-EUR / EURnom)
= (USDnom / EURnom) × (CPI-EUR / CPI-USD)
So when real exchange rates increases by 3% – and if that is the only information – we can’t tell what direction and size of changes are happening with nominal exchange rates and ratio of inflation between those countries. That’s what the last 2 sentences in the explanation meant.
Does this help?
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