anjali_pant 3 years ago Hey please explain in detail how changes in prices , real exchange rate , currency app/dep inter-related ?

1. sheg

Current Exchange Rate of Indian Currency against US Dollar is $1 = Rs 51.9995 and if this rate increases that is if$ 1 = Rs 52.9995 it will be called as Indian Rupee Depreciated against the US $by Re1. And if$ 1 = Rs 50.9995 it will be called as Indian Rupee Appreciated against the US $by Re1. Further the changes in the currency rate can be attributed to Balance of Trade Balance of Trade: It can be defined as the difference between its total exports with its total imports. Balance of Trade = Total Exports - Total Imports If it is positive then it is said to be a favorable position for the country because the foreign currency reserve of the country increases while if it is negative it is an unfavorable position because their would be an outflow from the foreign currency reserve it is also called as trade deficit. Trade balance impacts supply and demand for a currency. When a country has a trade surplus, demand for its currency increases because foreign buyers must exchange more of their home currency in order to buy its goods. A trade deficit, on the other hand, increases the supply of a country’s currency and could lead to devaluation if supply greatly exceeds demand. 2. anjali_pant And real exchange rate ? 3. sheg is above explanation clear to u?? 4. anjali_pant Yea , but I didnt have any problem in that ! Its just Iam not able to draw the relation b/w real exchange rate and currency app/depp ! How does changes in real exchange rate affect currency app/dep ! Moreover I had lot of problems in the same context , in Mundell fleming model where in the flexible exchange rate , domestic and foreign prices were assumed to be constant. If you could explain that as well , it would be gr888 ! :-) 5. sheg See the exchange rate difference between two countries currency happens on the basis of their foreign reserve that directly gets affected by the Balance of Payment. while the real exchange rate depends upon a number of factors such as the purchasing power parity(PPP) in this case we use $r_{ppp} = e {p_{f} \over P}$ where, $e$ nominal currency exchange rate $p_{f}$ is the price level in foreign country $p$ - price level in domestic currency 6. sheg so as u can see the domestic price level is in the denominator so whenever their is decline in the PPP it can be interpreted as appreciation in the real exchange rate 7. sheg so in the mundell and fleming model u having difficulty? 8. sheg see in that particular model Mundell and Fleming has said that their is a shift in the foreign exchange rate due to demand of domestic currency. For example as we know India is an Importer country while its exports are very low as compared to imports. I t means that the demand of Indian Currency is low in the foreign countries while as we are Importers so we are required to pay in terms of Foreign currency for that i am required to convert the INR into foreign currency so the foreign reserve of our country will decline. And according to MF model BOP surplus would be their when the demand of Domestic Currency is High due to higher amount of exports Due to this the Domestic Currency Appreciates BOP deficit would be their when the supply of Domestic Currency is high due to higher amount of imports Due to this the Domestic Currency Depreciates 9. anjali_pant but PPP happens when real exchange rate is 1 , so how can real exchange rate appreciate when there is PPP ? 10. sheg hey what do you mean by Purchasing Power Parity of any country??? 11. anjali_pant See at PPP , one can consume the same basket of good in domestic country as well as in foreign country. when R=1 ePf=P ( prices are same in domestic country as well as abroad ) 12. sheg ok i got your point thanks for your kind support see in this case u want to know the changes in the real exchange rate for example$ 1 = Rs 50. In this case if a good that is sold in US market at a price of $1 then it must be sold in Indian Market at a price of Rs 50. That's waht you want to say right 13. anjali_pant Noooo ! I know the concept of R , but want to know how changes in R lead to appreciation or depreciation of currency ! 14. sheg i feel this would help u plz explain it if u understand it because i m zero in economics........if u dont mind 15. anjali_pant Oh great ! By the way , Ive got the answer , shall I post it ? 16. sheg yeah please 17. anjali_pant anyways thanks for your persistent help and support ! :-) 18. sheg i m trying to understand the concepts of economics but as much as i m studying it i feel i know nothing 19. anjali_pant I will use the symbol R to denote the real exchange rate, which can be dened as R = eP P R is the relative price of foreign goods, as can be seen from the fact that R =$/foreign currency*foreign currency price of foreign goods $price of domestic goods =$ price of foreign goods \$ price of domestic goods An increase in R is known as a depreciation of the real exchange rate (the relative price of foreign goods rises) and a decrease in R is an appreciation of the real exchange rate (the relative price of foreign goods falls). So the critical dierence between a real exchange rate depreciation and a nominal exchange rate depreciation is that the former refers to an increase in the price of foreign goods in terms of domestic goods whereas the latter refers to an increase in the price of foreign currency in terms of domestic currency. Note also that nominal exchange rate appreciation (depreciation) can cause real exchange rate appreciation (depreciation), all else equal, i.e. if the price levels in the two economies either do not change or they change at the same rate (i.e. in ation rates are either zero in both countries, or if in ation rates are identical in both countries). However, real exchange rate appreciation (depreciation) can occur without a corresponding change in the nominal exchange rate - this is because of dierential changes in prices in the two countries (unequal in ation rates). A decrease in domestic prices (all else equal), an increase in foreign prices (all else equal), or a lower rate of in ation in the domestic economy will cause the real exchange rate to depreciate. An increase in domestic prices (all else equal), a decrease in foreign prices (all else equal), or a higher rate of in ation in the domestic economy will cause the real exchange rate to appreciate.

20. sheg

thanks

21. anjali_pant

http://www.wellesley.edu/Economics/weerapana/econ213/econ213pdf/lecture%20213-02.pdf the answer i mentioned is haphazard , so checkout this link ! Its there , and its awesome.