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LR Links of Real EXR to

Nominal EXR
LR Determinants of Nominal EXR
Relationship between nominal and real exchange rates.
e = e [PH/PF] or e = e [PF/PH]
where P = Domestic Price Level, etc.
Changes (D)in nominal exchange rate:
%D e = %D e + %D PF - %D PH
But %D P = Inflation rate = p, etc. so
%D e = %D e + (pF - pH)
Percent change in the nominal exchange rate equals the percent change in the real
exchange rate plus the difference in the two countries inflation rates.

Purchasing Power Parity, PPP
Purchasing Power Parity is the simplest theory of how real exchange
rates are determined.
Law of One Price:
A good cannot sell for different prices in different places at same time, i.e.
real exchange rate, e =1.
Law of One Price implies the real exchange rate is constant over time.
In long run should have: e = PF/PH
PPP limited as exchange rate theory:
Many goods & services are not tradable.
PPP good basis for understanding large moves in nominal exchange rate.

Relative Purchasing Power Parity, PPP
Relative Purchasing Power Parity
If PPP holds in terms of percent changes then:
%DPForeign = %De + %DPHome
Nominal exchange rate change approximated as:
%De = pForeign pHome
Where p is the inflation rate in the superscript country.
Relative purchasing power parity is:
1. A good forecast for exchange rates of countries that suffer from very high
inflation rates in both SR and LR.
2. Is less useful for SR forecasts when economies have similar inflation rates.