The massive U.S. trade deficit with China has become a political and economic issue, and whether its roots are in a fundamentally misaligned exchange rate is a point of contention.But, for the most part, economists and policymakers are more interested in the real To establish when a currency is misvalued, and, if so, by how much, a rough assessment can be obtained by the REER series over time.
But the fundamental notion is that when RERs diverge, the currencies face pressure to change. As with the absolute and relative RERs, there should be no changes if the currencies are in equilibrium. As arbitrageurs buy dollars to purchase Big Macs to sell in Germany, demand for dollars rises, as does the nominal exchange rate, until the price in Germany and the United States was the same—the RER returned to 1. While prices of tradables should tend to equalize across countries in the absence of trade barriers or currency controls, prices of nontradables can differ widely.
Real Effective Exchange Rate (REER) Let us calculate the real effective exchange rate (REER) component for China, India’s largest trading partner. Some large REER adjustments are remarkably smooth, suggesting that there may be factors besides transportation costs, tastes and tariffs that play a key role in influencing the REER of a currency that is not misaligned. In the real world there are many costs that get in the way of a straight price comparison—such as transportation, trade barriers, and consumption preferences. At 100 or close to 100, a currency is considered to be fairly valued. Yet, all the established fundamental FX valuation approaches are based on trade, not capital flows,” says Deutsche.In an attempt to better identify which currencies are overvalued or undervalued based on capital flows, Deutsche created its capital-based valuation model (Cap-PPP), something it says draws strong parallels with traditional trade-based PPP [purchasing power parity] modelling. Other countries have had similar experiences.But not all large REER fluctuations should be interpreted as indications of misalignment. It would make economic sense to buy dollars, use them to buy Big Macs in the United States at the equivalent of 1 euro, and sell them in Germany for 1.2 euros. That would be the case if the Big Mac costs $1.36 in the United States and 1 euro in Germany (or any other European country using the euro).
Nontradables, such as houses and many personal services, face minimal international price competition. In this one-product world (in which the prices equal the exchange rates) the purchasing power parity of the dollar and the euro is the same and the RER is 1 (see box).But suppose the burger sells for 1.2 euros in Germany. 3.40, for an RER of 1.2.One can measure the real exchange rate between two countries in terms of a single representative good—say the Big Mac, the McDonald’s sandwich of which a virtually identical version is sold in many countries. February 24, 2020
But not all goods in a given market basket are tradables and subject to international competition.
Technology changes that cause productivity increases in goods commonly traded between countries, called tradables, are thought to be one of those factors. Because productivity increases lead to lower production costs, the REERs would rise to maintain equilibrium. The real exchange rate, when managed carefully, can be a useful policy instrument to support the goals of structural change and export promotion.
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