Economic Development and Globalisation: Question 8

Worked solution

Part (a): Nominal versus real exchange rate

The nominal exchange rate is the rate quoted in the foreign exchange market at which one currency can be exchanged for another. It says nothing about what that money can actually buy in each country. The real exchange rate adjusts the nominal rate for the relative price levels (inflation rates) of the two economies, so that it reflects relative purchasing power and price competitiveness, not just the currency’s face value.

Part (b): Calculating the real exchange rate index

Using the formula given:

$\text{Real exchange rate index} = 108 \times \frac{112}{104}$

First, the price-index ratio: $\frac{112}{104} = 1.0769 \text{ (4 d.p.)}$

Then multiply by the nominal exchange rate index: $108 \times 1.0769 = 116.3 \text{ (1 d.p.)}$

So Halvorne’s real exchange rate index in Year 2 is $\boxed{116.3}$.

Part (c): Comparing nominal and real competitiveness

The nominal exchange rate index rose from 100 to 108, an appreciation of $8\%$. Taken alone, this might suggest Halvorne’s exports have become $8\%$ more expensive abroad (all else equal).

However, the real exchange rate index rose further still, from 100 to 116.3, a rise of about $16.3\%$. This is because Halvorne’s own price level rose faster ($12\%$, from 100 to 112) than its trading partners’ prices ($4\%$, from 100 to 104). This extra domestic inflation compounds with the nominal appreciation: Halvorne’s goods are not only priced in a stronger currency, they are also becoming relatively more expensive in their own right. The real exchange rate index therefore shows that Halvorne’s international price competitiveness has worsened by considerably more than the nominal exchange rate alone would suggest.

Part (d): Trade-weighted exchange rate

A trade-weighted exchange rate index measures the value of a currency against a basket of the currencies of a country’s main trading partners, with each partner’s currency given a weight based on its share of that country’s total trade. This gives a broader, more representative measure of a currency’s overall value than a single bilateral exchange rate, because a country typically trades with many partners at once, and its bilateral rate against any one of them can move quite differently from its rates against the others. A single bilateral rate could therefore give a misleading impression of what is actually happening to the currency’s overall value and competitiveness.

Final answers

• (a) Nominal rate = unadjusted market rate; real rate = nominal rate adjusted for relative price levels (competitiveness/purchasing power)
• (b) Real exchange rate index $=$ 116.3
• (c) Nominal appreciation alone (8%) understates the loss of competitiveness. The real appreciation (16.3%) is larger because Halvorne’s inflation (12%) exceeded its partners’ (4%)
• (d) A trade-weighted index is a weighted average of a currency’s value against ALL major trading partners, giving a more accurate overall picture than any single bilateral rate