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Nominal and real exchange rates
Real exchange rate can be defined as the purchasing power that different currencies have when they are evaluated and analyzed together. In this case, it is mostly based on two currencies (Sheffrin 2003, p. 16). Real exchange rate incorporates specific aspects like GDP deflator. Nominal exchange rate can be defined as the actual quotation in relation to a currency’s foreign exchange. In most occasions, this is in contrast to known rates.
Nominal exchange rates are normally adjusted to take care of any changes that might be witnessed in purchasing power. Real and nominal exchange rates are related in a broad way (Sheffrin 2003, p. 23). In this case, nominal exchange rate is related to real exchange rate because it takes various inflation differentials. As a matter of fact, real exchange rate can be defined from nominal exchange rate.
Because the nominal exchange rate can be termed as the actual exchange quotation, it is the more important for a country’s ability to export and import goods and services (Sheffrin 2003, p. 28). As a matter of fact, nominal exchange rate is important for any investor who is buying goods outside the country.
This is because it is specified without any adjustments. Such adjustments can be in relation to purchasing power and various transaction costs (Sheffrin 2003, p. 32). In this case a country will be able to factor in all costs and aspects of business before it can export or import.
The theory of purchasing power parity
The theory of purchasing power parity revolves around long term equilibrium. This is in relation to exchange rates. As matter of fact, it is based on price levels. It should be known that this is mostly between two countries (Sheffrin 2003, p. 16). The theory of purchasing power parity is of the idea that when there are no transaction costs, identical goods and services should be having the same price in different countries.
Big Mac Index
The price of Big Mac in USA in US dollars is $ 3.73 while in Australia; the price is A$ 4.35. In this case, the implied PPP value for the Australian dollar is 1.17. In January 17 2009, the exchange rate between the Australia dollar and the US dollar was 1 USD = 1.0031 AUD (RBA 2011, p. 132).
In this case, one Australian dollar was 0.99687 USD. Currently, (In January 17 2011) the exchange rate is 0.9877. This is calculated on a trade weighted index of 73.8 (RBA 2011, p. 28). Currently, the exchange rate seems to be undervalued because of the strength of the American dollar. As a matter of fact, the American dollar is highly overvalued and this therefore undervalues the Australian dollar in a broad way.
There are various assumptions that underly this changes that have been witnessed in exchange rates between the Australia dollar and the US dollar. The Australian dollar has been going up because of various issues and factors. RBA has been instrumental in ensuring that this exchange rate stays at 0.9877 (RBA 2011, p. 12). For instance, interest rates have been lowered to reduce the demand for Australian dollars.
Such aspects and a good economic growth rate have been responsible for these fluctuation and variations in the Australian dollar. Various imbalances have been unsustainable and this could be the reason why the Australian dollar is undervalued (RBA 2011, p. 19). As a matter of fact, this could be the reason why it has been gaining momentum in recent years as time goes by.
RBA., 2011. Exchange Rates. Available at: https://www.rba.gov.au/statistics/frequency/exchange-rates.html .
Sheffrin, M, S., 2003. Economics: Principles in action. New Jersey: Prentice Hall.