Because measures of groups of goods and services are

– 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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11
Figure 16.3 Price Levels and Real
Incomes, 2010
The 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 rate is the rate of exchange for goods
and services across 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:
 
$ / € EU
US
US
EU
E P
q
P


The Real Exchange Rate Approach to
Exchange Rates
(2 of 10)
 
$ / € EU
US
US
EU
E P
q
P


– If 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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The Real Exchange Rate Approach to
Exchange Rates
(3 of 10)
 
$ / € EU
US
US EU
E P
q
P


– A 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
$ / €
EU
P
E
P

• According to the more general real exchange rate
approach, exchange rates may also be influenced by the
real exchange rate:
US
$ / € US
EU EU
P
E q
P
 
• What influences the real exchange rate?
The Real Exchange Rate Approach to
Exchange Rates
(5 of 10)
• A change in relative demand of U.S. products
– An 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: P
US
rises
relative to
$ / € EU
E P 
– The 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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The Real Exchange Rate Approach to
Exchange Rates
(6 of 10)
• A change in relative supply of U.S. products
– An 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.