The Real Exchange Rate and Purchasing Power

The real exchange rate and purchasingpower

parity (PPP)

Look at the real exchange rate formula more closely. The real exchange

rate is equal to e × P / P*. Take our earlier example of the Hong Kong

dollar versus the RMB. Suppose that on average, goods and services in

Hong Kong are exactly five times more expensive than those in

mainland China. Then, from the perspective of Hong Kong, domestic

price / foreign price = 5. The nominal exchange rate of RMB is

RMB$1.0/HK$1. So, the real exchange rate of RMB is equal to the

nominal exchange rate × (domestic price / foreign price) = 1.0 × 5 =

5.0. You have gone through this in the previous subsection.

You can rewrite it in the following way:

Real exchange rate = e × P / P* = (RMB$/HK$1) × (HK$ per basket

of goods and services in Hong Kong) / (RMB$ per basket of goods

and services in China)

= relative cost of a basket of goods and services in Hong Kong to the

cost of a basket of goods and services in China.

Thus, the real exchange rate measures the relative cost of a basket of

goods and services in the home economy, relative to that in the foreign

country. In our example, the real exchange rate of RMB against the

Hong Kong dollar is 5.0. That means the same basket of goods and

services costs five times as much in Hong Kong as it costs in China.

Note that when the domestic currency appreciates in terms of the real

exchange rate, the relative cost of goods and services rises in the

domestic economy. But it sounds like the value of the domestic currency

decreases (that is, depreciation occurs in terms of the nominal exchange

rate) because the domestic currency can now buy less goods and

services! However, this is not the case. Please review question 2 and in

particular question 2(a) in Self-test 6.2.

When the real exchange rate of the Hong Kong dollar appreciates, Hong

Kong goods and services become more expensive