Answer to Question #154570 in Macroeconomics for Dominika

Question

Initially, the nominal exchange rate corresponds to purchasing power parity. In the following year, inflation in the Czech Republic is higher than abroad.

 1. What should be the development of the nominal exchange rate according to the dynamic version of the PPP?

 2. If the nominal exchange rate follows a dynamic version of the PPP, what impact will this have on domestic exporters?

 3. If the nominal exchange rate remains unchanged, what are the effects on the real exchange rate and the exporter?

Answer 1

1.According to the relative PPP, the dynamics of the nominal exchange rate depends on the rate of inflation in the countries under consideration, i.e. the nominal exchange rate changes in such a way as to compensate for the differences in price level changes in different countries.

2.Theoretically, the depreciation of the currency creates conditions for import substitution, and the appreciation of the ruble reduces the competitiveness of domestic goods in relation to imported ones, which can restrain the establishment of exports of products.

3.The nominal exchange rate may remain unchanged, but the rate of inflation affects the real exchange rate. The real exchange rate is the nominal exchange rate adjusted for the ratio of price levels in a given country and in other countries (trading partner countries), i.e. it is the relative price of a unit of goods and services produced in two countries.

Change in the price level abroad (RF): the higher the price level abroad, the higher the real exchange rate. When the price level abroad increases, it becomes more profitable for foreigners to buy relatively cheaper goods produced in a given country. Conversely, a decrease in the level of prices abroad reduces the desire of foreigners to buy relatively more expensive goods produced in a given country, while the desire of citizens of the country to buy foreign goods increases.

Change in the price level in a given country (P): the higher the price level in a given country, the lower the real exchange rate. An increase in the price level in the country leads to a decrease in the demand for more expensive goods of this country from foreigners. While the decline in the price level in a given country makes the goods produced in it more attractive to foreigners.