Answer to Question #189286 in Macroeconomics for celeste

Question

a) Define nominal exchange rate (NER) and real exchange rate (RER).

b) What happens to the U. S. real exchange rate (RER) and its net exports (NX) under the following situations?

i)    The U.S. NER is unchanged, the U.S. price rises, foreign price stays the same.

ii) The U.S. NER is unchanged, the U.S. price unchanged, foreign price rises.

iii) The U.S. NER rises, the U.S. price remains same, foreign price stays the same.

iv) The U.S. NER is unchanged, the U.S. price falls, foreign price falls.

v) The U.S. NER falls, the U.S. price rises, foreign price stays the same

Answer 1

(a)

The Nominal Exchange Rate is defined as the rate at which an individual can trade its currency for the currency of another nation. It measures the amount of currency that can be bought in exchange for the currency of another nation.

Real Exchange Rate is defined as a measure to compare the relative prices of two nations consumption baskets. A consumer may want to know how much one dollar can buy in the Euro-zone countries or what one Euro can buy in the U.S. This can be determined with the help of a Real Exchange Rate. To calculate the Real Exchange Rate, the prices of the consumption baskets of the two countries and the Nominal Exchange Rate is to be known.

A country's basket specifies how much an average consumer buys and the price indicates how much the consumer pays for it.

The Real Exchange Rate can be calculates as:

$Real$  $Exchange$ $Rate=$ $Nominal$ $Exchange$ $Rate \times$ $\frac{Domestic Price}{Foreign price }$

(b)

(i) The U.S. NER is unchanged, the U.S. price rises, foreign price stays the same.

If the Nominal Exchange Rate of the United States remains unchanged and the prices in the U.S rises. This means that the Real Exchange Rate in the U.S is high and the relative prices of the goods at home are much higher than the relative price of goods in a foreign country. In this case, U.S will import the goods since its price is cheaper in other foreign countries compared to the price at home. Therefore, when Real Exchange Rate is high, Net exports decrease as imports rise.

(ii) The U.S. NER is unchanged, the U.S. price unchanged, foreign price rises.

If the Nominal Exchange Rate in the U.S in unchanged along with its price level, but the foreign price rises. This implies that the Real Exchange Rate is low and the relative prices of the good are comparatively cheaper at home than abroad. In such a case. U.S will export its goods to other countries since the relative price of the goods are cheaper at home. Therefore, when Real Exchange Rate is low, the net exports are increase as exports rise and imports fall.

(iii) The U.S. NER rises, the U.S. price remains same, foreign price stays the same.

When there is a rise in the Nominal Exchange Rate, while the price at home and abroad remains the same, there is no change in the real exchange rate and there is a balance in the net exports of the country.

(iv) The U.S. NER is unchanged, the U.S. price falls, foreign price falls.

In this part of the question, I'm assuming that the ratio of fall in price between the U.S and foreign is the same.

so as a given situation, NER is unchanged, the price of both the U.S and Foreign falls with the same proportion. Due to this there is no change in the real exchange rate, so if there is no change in real exchange rate this means there is the proper balance between the net exports of the country.

(v) The U.S. NER falls, the U.S. price rises, foreign price stays the same

If the Nominal Exchange rate falls along with the rise in the price of the U.S and the price of foreign remains constant this means the real exchange rate will increase, so if the real exchange rate increases, U.S export will fall, and there is a rise in the imports.