Download Interpreting Economic Data:

Interpreting Economic Data:
Calculating the real exchange rate
In this column in the February 2004 issue, Paul turner discussed
how to calculate the real effective exchange rate, and as usual
provided some exercises for students to work through. Here are
some guideline responses, which should be read in conjunction with
the Excel spreadsheet also provided on the website.
Questions
1. Using the data in Table 4 and the weights given in the article,
calculate values for the nominal effective exchange rate over the
period 1995 to 1998.
Table 4: Units of national currency per £
1995
1996
1997
1998
French Franc Deutschmark
7.88
2.26
7.99
2.35
9.56
2.84
9.77
2.91
Italian Lira
2570.5
2410.1
2789.7
2875.2
Japanese Yen
148.4
169.9
198.2
216.8
US Dollar
1.58
1.56
1.64
1.66
The figures in the Table show units of national currency per pound sterling.
The calculations can be seen in the Excel spreadsheet. The first
step is to convert the data in Table 4 to index numbers, as
otherwise they cannot be combined into an effective exchange rate
index.
In other words, the conversion into index numbers
overcomes the problem of differing national currency units. For
example, a simple average would overstate the importance of the
Lira, and understate the US$. Table 4a on the spreadsheet carries
out these calculations. We can then combine the index numbers
into a single index, which is shown in the final column of the
spreadsheet table. This involves taking a weighted average of the
index numbers. the weights are shown in Row 14, and you can look
at the formula in cells G9:G12 to see how the calculations are
carried out.
2. It is often argued that the exchange rate appreciates when the
monetary authorities increase the interest rate. Discuss reasons
why this might be the case.
The most obvious reason is that if UK interest rates rise relative to
those in other countries, then investors will tend to move funds into
the UK in search of a high return. This will tend to put upward
pressure on the nominal exchange rate. A higher interest rate may
also affect expectations about future inflation, and increase
confidence in the UK economy.
3. Using the data in the Table below calculate a real exchange rate
index for the Japanese Yen relative to the Pound Sterling and
comment on your results.
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Yen/£ Exchange
Rate
258.5
238.3
223.7
167.0
156.6
148.4
169.9
198.2
216.8
184.3
163.4
175.0
188.2
Japanese Price
Index
100.0
103.2
105.0
106.4
107.1
107.0
107.1
109.0
109.7
109.3
108.6
107.8
106.8
UK Price
Index
100.0
105.9
109.8
111.5
114.3
118.2
121.1
124.9
129.1
131.1
135.0
137.4
139.7
Table 5 has been reproduced in the spreadsheet, and I have added
an extra column (see cells E18:E30) with the calculation of the real
yen exchange rate. This simply multiplies the nominal exchange
rate by the ratio of UK:Japanese prices. Figure 1 plots the timepaths of the nominal and real exchange rates:
Figure 1:
Nominal and real exchange rates (Yen/£)
300
250
Yen/£
200
150
100
50
0
1990
1992
1994
1996
Nominal
1998
2000
2002
Real
Although both series fluctuate through time, the real exchange rate
is seen to fluctuate around a level, rather than around a trend. This
is what we expect to happen if the nominal exchange rate adjusts in
order to counter differences in inflation between countries.
Notice that this was an unusual period for the Japanese economy,
which was in deep recession for much of the 1990s. This was
discussed by Maurice Kugler in an article in the November 2003
issue of Economic Review.
Peter Smith
March 2004