The goods of the other country c appreciation and

the goods of the other country
C) Appreciation and depreciation
1. In a flexible-exchange-rate system, when e
nom
falls, the domestic currency has undergone a
nominal depreciation (or it has become weaker); when e
nom
rises, the domestic currency has
become stronger and has undergone a nominal appreciation
2. In a fixed-exchange-rate system, a weakening of the currency is called a devaluation, a
strengthening is called a revaluation
3. We also use the terms real appreciation and real depreciation to refer to changes in the real
exchange rate
Numerical Problem 1 is a simple example of appreciation and depreciation.
D) Purchasing power parity
1. To examine the relationship between the nominal exchange rate and the real exchange rate,
think first about a simple case in which all countries produce the same goods, which are
freely traded
a. If there were no transportation costs, the real exchange rate would have to be e = 1, or
else everyone would buy goods where they were cheaper
b. Setting e = 1 in Eq. (13.1) gives
P = P
For
/ e
nom
(13.2)
c. This means that similar goods have the same price in terms of the same currency, a
concept known as purchasing power parity , or PPP
d. Empirical evidence shows that purchasing power parity holds in the long run but not in
the short run because in reality, countries produce different goods, because some goods
aren’t traded, and because there are transportation costs and legal barriers to trade
2. When PPP doesn’t hold, using Eq. (13.1), we can decompose changes in the real exchange
rate into parts
∆ e/e = ∆ e
nom
/ e
nom
+ ∆ P/P – ∆ P
For
/ P
For

Chapter 13 Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy 9
3. This can be rearranged as
∆ e
nom
/ e
nom
= ∆ e/e + π
For
– π (13.3)
4. Thus a nominal appreciation is due to a real appreciation or a lower rate of inflation than in
the foreign country
5. In the special case in which the real exchange rate doesn’t change, so that ∆ e/e = 0, the
resulting equation in Eq. (13.3) is called relative purchasing power parity , since nominal
exchange-rate movements reflect only changes in inflation
a. Relative purchasing power parity works well as a description of exchange-rate
movements in high-inflation countries, since in those countries, movements in relative
inflation rates are much larger than movements in real exchange rates
6. Box 13.1: McParity
a. As a test of the PPP hypothesis, the Economist magazine periodically reports on the
prices of Big Mac hamburgers in different countries
b. The prices, when translated into dollar terms using the nominal exchange rate, range
from just over $1 in China to over $4 in Switzerland (using 2003 data), so PPP definitely
doesn’t hold
c. The hamburger price data forecasts movements in exchange rates
(1) Hamburger prices might be expected to converge, so countries in which Big Macs
are expensive may have a depreciation, while countries in which Big Macs are cheap
may have an appreciation
E)The real exchange rate and net exports
1. The real exchange rate (also called the terms of trade) is important because it represents the