Real Interest Rate

THE UNIVERSITY OF MANCHESTER

MANCHESTER BUSINESS SCHOOL

Further Detailed Notes to accompany the lectures on the

accredited Exchange Rate

THE REAL EXCHANGE RATE

In the following discussion, the theater or domestic help economy is assumed to be the USA.

The reliable substitution rate compares legal injurys of goods produced in the domestic economy with prices of goods produced overseas. It is a measure of congeneric prices.

The real exchange rate is weighty for (a) the composition of production and (b) the consumption choices between domestic and international goods.

The real exchange rate is part of the mechanism that enforces the intertemporal reckon constraint for a country.

For the comparison of prices of goods produced at dwelling with prices of goods produced abroad to be useful and unambiguous, the prices should be measured in units of the alike funds. To achieve this, we make use of the nominal exchange rate, S.

The exchange rate S is expressed as the number of units of domestic currency ($) per unit of foreign currency (for example, $s per €).

allow P* denote the price of foreign goods expressed in foreign currency (say, €s).

Let P denote the price of domestic goods expressed in domestic currency (say, $s).

So S.P* is the price of foreign goods expressed in domestic currency ($s).





Then the real exchange rate, Q, the price of foreign goods relative to the price of domestic goods (where both are expressed in terms of units of the domestic currency) is

Q = SP*/P(1)

or, in logarithms:

q = s + p* - p (2)

where lowercase letters denote logarithmic values.

If haughty purchasing power parity holds (so the cost of a wicket of goods represented by these price indices is the same in the home and foreign countries, when measured in units of the domestic currency), then Q is uninterrupted and equal to 1 (or q = 0).

However, actual data on Q reveals that it is intelligibly not constant.[1] This is a well-known fact. In the...If you want to shrink a full essay, order it on our website: Orderessay



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