Thursday, 3 May 2012

Exchange rates: real and nominal

Recently there has been much talk of the need for a "lower exchange rate" to help our exporters. Somewhat strangely - to me at least - no one appears to have bought up the difference between the nominal and real exchange rate, all the talk seems to be in terms of the nominal rate.

The real exchange rate can be defined as the nominal exchange rate that takes the inflation differentials among the countries into account. Its importance stems from the fact that it can be used as an indicator of competitiveness in the foreign trade of a country. We can denote the real exchange rate (r) as the nominal exchange rate (e) that is adjusted by the ratio of the foreign price level (P_f) to the domestic price level (P), that is r=e(P_f /P). Importantly it is the real rate that determines whether exports are cheaper and imports more expensive.

Note that this definition implies that if, for example, there is a 20 per cent devaluation but the local price level increases by 20 percent then exporters and those businesses competing with imports are no better - or worse - off than if the devaluation had not occurred. Thus "loose" monetary policy may lower the nominal exchange rate but would also increase inflation thereby leaving the real exchange rate little changed.

It is true that in the short-term there are benefits of a lower exchange rate, but the important expression here is "short-term". In the short-term a lower exchange rate will increase economic activity and favour exporters. However, businesses will be responding to price signals that cannot be maintained and the painful reallocation of resources will have to take place once the short-term benefit has come to an end. Maintaining the low exchange rate will require loose monetary policy and this will bring about inflation and a rise in the internal price level.

Back to the point that it is real exchange rates that determines the cost of exports and imports relative to alternatives. Real exchange rates are determined by real factors – they are only a function of monetary policy in the short term. The most pertinent of these real factors is the level of private saving and government borrowing. If a country is a net borrower, the counterpart of this must be a current account deficit (capital account surplus). The inflow of capital will bid up the exchange rate and bring this counterpart about. The government could help things by reducing its borrowing and not discouraging saving.

Note that New Zealand does not incur debts because its exchange rate is "too high". A trade deficit occurs because we choose to incur debt, i.e. we borrow from overseas. On the other side of the coin countries like Japan have not accumulated assets because there exchange rate is weak, rather their exchange rate is weak because they have been accumulating assets.

We should keep in mind that in the long-term monetary policy, actions by the Reserve Bank, affects the nominal exchange rate but it is real factors that affect the real exchange rate. This means that all the talk about a lower exchange rate will amount to little simply because the Reserve Bank can't affect the real factors underlying the real exchange rate enough over the longer term.