real exchange rate....doubt....

CFA Level I
#1

please explain me the following…

a real exhange rate is an increasing function of the nominal exchange rate(dc/fc) and foreign price level…

and a decresing function of domestic price level…

thanks

#2

The relationship between nominal exchange rates (dc/fc) and real exchange rates (dc/fc) is:

R_nom_ = R_real_ × (1 + inf_d_) / (1 + inf_f_),

or,

R_real_ = R_nom_ × (1 + inf_f_) / (1 + inf_d_).

Thus,

  • As the nominal exchange rate increases, the real exchange rate increases
  • As the foreign price level (inflation) increases, the real exchange rate increases
  • As the domestic price level (inflation) increases, the real exchange rate decreases.

You should know the top formula and be able to manipulate it to get the relationships mentioned above; you should not memorize these relationships.

#3

as always

thank u so much…

#4

My pleasure.