David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 24 Exchange rates and the balance of payments
Table 24.2
Balance of payments and exchange rate regimes
Fixed exchange rate
current account
Floating exchange rate
current account
+ capital account +capital account
+financial account
+financial account
= balance of payments = balance of payments
= [-official financing] =0
I---
= rise in forex reserves No official financing; no change in forex reserves
The real exchange rate
The real exchange rate
is the relative price of goods
from different countries when
measured in a common
currency.
In 1981 the $/£ exchange rate was $2.03/£; by early 2010 it was only $1.54/£. A fall
in the international value of sterling makes UK goods cheaper in foreign currencies
and foreign goods more expensive in pounds. Other things equal, the UK became
more competitive as sterling fell.
But other things were not unaltered. The UK had more inflation than the US, so its
prices rose more during 1981-2010. UK competitiveness rose because of a lower
nominal or actual exchange rate, but fell because the sterling price of UK goods rose more than the dollar
price of US goods. As usual, we must distinguish nominal and real variables.
Thus if E $t£ is the nominal exchange rate, measured by$/£ the international value of sterling, and ptK and
Pts are the domestic sterling price of UK goods and the dollar price of US goods,
Real exchange rate = {E s t£
x ptdlPts (1)
Table 24.3 gives some examples. Pretend the only good is shirts. In row 1, a US shirt costs $10 and a UK
shirt £6. At a nominal exchange rate of $2/£, the relative price of UK to US shirts, in a common currency,
is 1.2, whether we compare the relative dollar price of shirts ($12/$10) or the relative price in pounds
(£6/£5). Two things can make UK shirts more competitive in relation to US shirts.
Table 24.3
Calculating real exchange rates
Nominal exchange UK shirt price UK shirt price US shirt price Real exchange
rate ($/£)
($)
rate
(£)
2.0 6 12 10 1.2
-
6 9 10 0.9
1.5
2.0
9 10 0.9
I---
2.0 6 1 2 13.3 0.9
4.5
($)
556