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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