Because measures of groups of goods and services are different the measure of

Because measures of groups of goods and services are

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Because measures of groups of goods and services are different, the measure of their average prices need not be the same.One price need not hold in two markets.Law of One Price for Hamburgers?
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2/4/201911Figure 16.3 Price Levels and Real Incomes, 2010The Real Exchange Rate Approach to Exchange Rates (1 of 10)Because of the shortcomings of PPP, economists have tried to generalize the monetary approach to PPP to make a better theory.The real exchange rateis the rate of exchange for goods and servicesacross countries. In other words, it is the relative value/price/cost of goods and services across countries.For example, it is the dollar price of a European group of goods and services relative to the dollar price of an American group of goods and services:$ / €EUUSUSEUEPqPThe Real Exchange Rate Approach to Exchange Rates (2 of 10)$ / €EUUSUSEUEPqPIf the EU basket costs €100, the U.S. basket costs $120, and the nominal exchange rate is $1.20 per euro, then the real exchange rate is 1 U.S. basket per 1 EU basket.A real depreciation of the value of U.S. products means a fall in a dollar′s purchasing power of EU products relative to a dollar′s purchasing power of U.S. products.This implies that U.S. goods become less expensive and less valuable relative to EU goods.This implies that the value of U.S. goods relative to value of EU goods falls.
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2/4/201912The Real Exchange Rate Approach to Exchange Rates (3 of 10)$ / €EUUSUSEUEPqPA real appreciation of the value of U.S. products means a rise in a dollar’s purchasing power of EU products relative to a dollar’s purchasing power of U.S. products.This implies that U.S. goods become more expensive and more valuable relative to EU goods.This implies that the value of U.S. goods relative to value of EU goods rises. The Real Exchange Rate Approach to Exchange Rates (4 of 10)According to PPP, exchange rates are determined by relative average prices:US$ / €EUPEPAccording to the more general real exchange rate approach, exchange rates may also be influenced by the real exchange rate:US$ / €USEUEUPEqPWhat influences the real exchange rate?The Real Exchange Rate Approach to Exchange Rates (5 of 10)A change in relative demandof U.S. productsAn increase in relative demand of U.S. products causes the value (price) of U.S. goods relative to the value (price) of foreign goods to rise.A real appreciation of the value of U.S. goods: PUSrises relative to$ / €EUEPThe real appreciation of the value of U.S. goods makes U.S. exports more expensive and imports into the U.S. less expensive (thereby reducing the relative quantity demanded of U.S. products).A decrease in relative demand of U.S. products causes a real depreciation of the value of U.S. goods.
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2/4/201913The Real Exchange Rate Approach to Exchange Rates (6 of 10)A change in relative supplyof U.S. productsAn increase in relative supply of U.S. products (caused by an increase in U.S. productivity) causes the price/cost of U.S. goods relative to the price/cost of foreign goods to fall.
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