If you put 100 pounds in a bank, and earn 8% interest over the year (eight pounds interest), this is only the nominal rate of interest. What you really get - the real rate of interest - depends on the rate of inflation as well. If inflation was running at 5% over the year, then the real rate of interest was only 3% (8% − 5%). Your 100 pounds became 108 pounds, but goods and services costing 100 pounds a year ago now cost 105 pounds. In real terms you have only really made 3 pounds.
The nominal exchange rate between, say, the pound and the dollar is simply the amount of dollars you can buy for each pound as dictated by the price in the foreign exchange markets. To find the real exchange rate, we have to allow for relative inflation rates in the two countries, just as you do with interest rates, of growth, or spending, or incomes or anything where the price rises distort the picture.
In this case, the picture that is being distorted is the UK's competitiveness, in terms if trade, with other countries. If the trade weighted index for sterling fell by, say, 5% over a given year, this would make UK manufacturers' exports 5% cheaper in foreign countries. If sterling falls, UK manufacturers are happy! But if, over the same period of time, prices in the UK rose by 5%, the benefit in terms of the reduced value of the pound for UK manufacturers would be cancelled out by the higher domestic prices.
The real exchange rate tries to take relative changes in countries' inflation rates into account. Look at the formula below:
In this formula, the 'world' price level is an average of the price levels of the sixteen countries that are included in the trade weighted effective exchange rate. Assume that the UK's effective exchange rate stays constant over a given year. If UK inflation is 10% over that year, and world inflation is only 7%, then the real exchange rate will rise by roughly 3% (10% − 7%). The exact rise would be 2.8%. See if you can work out why it is not exactly 3%. Read through the following example, trying to understand the principles,click to reveal answer when you have finished.
Assume that the RPI in the UK is 100 and the RPI for the rest of the world also happens to be 100. Hence:
In the example above, we said that UK inflation was 10% over the given year. This gives a new RPI of 110. In the same way, the new RPI for the rest of the world will be 107. So the new ratio of price levels will be:
So the ratio has risen by 0.028. As a percentage (multiplying by 100) this is 2.8%.
The problem for the UK during the 70s and 80s was that, regardless of how low the effective exchange rate was, its inflation rate tended to be higher than the world average. This caused the real exchange rate to rise (for a given effective exchange rate), making UK exports relatively more expensive abroad and so less competitive pricewise
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