# Introduction to nominal, real and trade-weighted exchange rates

In this video we will introduce the definitionof the exchange rate and explore how it is measured.

Per the CIE syllabus we will consider thenominal, real and trade-weighted exchange rates.

The definition you should be aware of is thatthe exchange rate is the rate at which one currency is exchanged for another.

The board you see on the right is the oneyou’ve probably encountered at an airport currency conversion counter.

Rates published here are examples of the nominalexchange rate.

To explain the real exchange rate I’ll quotefrom the IMF website referenced below: “One can measure the real exchange ratebetween two countries in terms of a single representative good—say, the Big Mac, theMcDonald's sandwich of which a virtually identical version is sold in many countries.

If the real exchange rate is 1, the burgerwould cost the same in the United States as in, say, Germany, when the price is expressedin a common currency.

That would be the case if the Big Mac costs\$1.

36 in the United States and 1 euro in Germany.

In this one-product world (in which the pricesequal the exchange rates), the purchasing power parity (PPP) of the dollar and the eurois the same and the RER is 1 (see box).

In this case, economists say that absolutePPP holds.

But suppose the burger sells for 1.

2 eurosin Germany.

That would mean it costs 20 percent more inthe euro area, suggesting that the euro is 20 percent overvalued relative to the dollar.

If the real exchange rate is out of whack,as it is when the cost is 1.

2, there will be pressure on the nominal exchange rate toadjust, because the same good can be purchased more cheaply in one country than in the other.

It would make economic sense to buy dollars,use them to buy Big Macs in the United States at the equivalent of 1 euro, and sell themin Germany for 1.

2 euros.

Taking advantage of such price differentialsis called arbitrage.

As arbitrageurs buy dollars to purchase BigMacs to sell in Germany, demand for dollars will rise, as will its nominal exchange rate,until the price in Germany and the United States is the same—the RER returns to 1.

In the real world, there are many costs thatget in the way of a straight price comparison—such as transportation costs and trade barriers.

But the fundamental notion is that when RERsdiverge, the currencies face pressure to change.

For overvalued currencies, the pressure isto depreciate; for undervalued currencies, to appreciate.

It can get more complicated if factors suchas government policies hinder normal equilibration of exchange rates, often an issue in tradedisputes.

” For further reading on the real exchange rate,follow the IMF link in the video notes below to open a short two page summary on real exchangerates which provides good information for both students and teachers to use.

Some of you may have discussed the Big MacIndex in your economics classes to compare the real value of currencies relative to theUS dollar.

In this image we can see that \$100 buys about23 Big Macs in the US.

This chart from the Economist shows you howmany Big Macs \$100 buys in the respective countries (using 2012 dollars).

If you can buy more than 23 Big Macs, suchas in China and Mexico, it is assumed the currency is undervalued and will tend to appreciatein the long run.

If it buys less than 23 Big Macs, such asin countries like Australia and Denmark, it is assumed that the currency is overvaluedand will tends to depreciate in the long run.

The trade weighted exchange rate is a weightedaverage of exchange rates of the domestic currency versus foreign currencies.

The weight for each foreign country is setby its share in trade.

To illustrate, let’s look at a past multiplechoice question from the CIE winter 2013 paper.

Country X trades with only two countries,the USA and Japan.

90% of the country’s trade is with the USAand 10% is with Japan.

The original value of the trade-weighted exchangerate index is 100.

The value of country X’s currency againstthe US\$ rises by 10%.

The value of country X’s currency againstthe Japanese yen rises by 50%.

What will be the value of country X’s newtrade-weighted exchange rate index? While this problem looks tricky, it is quiteeasy to solve when we break it down.

To calculate the trade weighted exchange ratewe simply increase the basket from 100 to 110 and multiply by 90 to value the impactof the change against the American currency.

We then appreciate the basket from 100 to150 and multiply by 10 to value the impact of the change against the Japanese currency.

We add these two figures together and dividethis sum by 100 to get to our answer of 114.

That wraps ups this introduction to the exchangerate and I hope it helps you develop your understanding.

If you have any questions, please feel freeto leave them below or email me at enhancetuition@gmail.

Com.

You can also tweet me @enhancetuition andvisit me soon on www.

Enhancetuition.

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I’ll be posting a video once the websiteis live.

As always, thanks for watching and I willsee you in the next one!.