Real Exchange Rate RER

1
Real Exchange Rate (RER)

• The RER is often defined as the relative price of
  foreign to domestic goods. This variable can also
  be thought of as a measure of competitiveness, Q
• Q P/(P/S) SP/P
• where P is measured in dollars per unit of the
  foreign good, P is measured in baht per unit of
  the good produced in Thailand and S is the
  exchange rate in baht/

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Two ways of viewing the RER

• Note that P and S/P are prices in dollars.
  Therefore P/(S/P) gives relative prices of
  foreign and Thai goods, as viewed by someone from
  USA, who converts all prices to dollars.
• Since SP and P are prices in baht, the ratio
  SP/P gives relative prices of foreign and Thai
  goods, as viewed by someone from Thailand who
  converts all prices to baht.

3
Real appreciation and real depreciation

• Depreciation of the baht means a fall in the
  value of the baht. That means a rise in S, the
  exchange rate in baht/.
• Real depreciation of the baht against the
  dollar means a fall in the value of home goods,
  relative to the value of foreign goods. That
  means a rise in Q.

4
Confusing terminology

• This can be a source of confusion real (nominal)
  appreciation is associated with a fall and
  depreciation with an increase in the real
  (nominal) exchange rate.
• Since the terminology used here is used
  throughout most of the world, there is not much
  we can do about this possible confusion, except
  to guard against it.

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• This is not the only way of defining the real
  exchange rate. The RER can also be defined as the
  relative price of traded goods to non-traded
  goods.
• In this course we will ignore non-traded goods
  and assume that all goods are traded. In the
  alternative framework, it is assumed that the
  imported good and the exported traded goods are
  both produced in Thailand and that they are also
  both produced in the rest of the world.

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• In contrast in the framework that we adopt,
  there are just two goods, imports and exports.
  The home country produces only its export good
  and the foreign country produces only the good
  that we import. This makes the real exchange rate
  identical to the terms of tradethat is the price
  of exports relative to the price of imports.
• This is quite a restrictive assumption!

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• In the alternative framework, there are 3 goods
  imports, exports, non-traded goods. The terms of
  trade are usually taken as exogenous and units
  defined so that the dollar prices of both imports
  and exports are unity.
• The real exchange rate is therefore different to
  the terms of trade. This makes the alternative
  framework more general, but harder to analyze.
• In most contexts the two frameworks give similar
  answers, so we use the simpler one.

8
Estimating the RER for Thailand

• Both the framework that we use and the
  alternative one just described are gross
  oversimplifications of the real world, in which
  there are millions (trillions?) of different
  types of goods, not just two or three.
• Since there are lots of home goods and lots of
  domestic goods, there are lots and lots of
  different ways of measuring the real exchange
  rate.

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• One very simple way of measuring Thailands RER
  is to use the data from the PPP slides.
• Recall that we estimated the US CPI and the Thai
  CPI converted to US dollars. The ratio of these
  two indices gives a measure of US prices,
  relative to Thai prices, with both measured in
  the same currency that is, it is a measure of
  P/(P/S)

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• The graph shows that during the long period from
  1985 to 1996 there was a steady appreciation of
  the RER. That is, a decrease from 106 in 1985 to
  89 in 1996. As viewed by Thais, US prices fell,
  relative to home prices, by 16. As viewed by
  Americans, Thai prices rose, relative to US
  prices by 19.

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• Then came the crisis and the RER depreciated from
  89 in 1996 to 149 in 2003
• As viewed by Thais, US prices rose relative to
  Thai prices by 64. As viewed by Americans,
  Thai prices fell relative to American prices by
  39.
• Why the different numbers? Suppose that, with P
  and P constant, S doubles. Thais think US prices
  in baht have risen by 100. Americans think Thai
  prices in dollars have fallen by 50.

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• Why compare Thai prices with US prices, rather
  than Australian, Indonesian or any other
  countries prices?
• Suppose we use Indonesian prices. This would
  roughly reverse the story in the crisis because
  the real depreciation of the rupiah against the
  dollar was much bigger than of the baht.
• It also roughly reverses the story in the
  pre-crisis period.

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• The best RER measure for Thailand would be a
  weighted average of the RERs against all
  Thailands trading partners, with weights
  proportional the importance of each partner in
  Thailands total trade.
• I dont think that this ideal RER measure would
  be very different to the BHT/ RER. The BHT/RP
  series would get a small weight and the series
  for BHT/YEN, BHT/EURO, BHT/M, BHT/S etc would
  probably all look at least fairly similar to the
  BHT/ series.

17

• Is real exchange rate appreciation good or bad?
• Answer it all depends!
• Suppose you have a part time job. What is your
  real exchange rate relative to the rest of the
  world? Its your money wage (baht/hour) deflated
  by the prices of the things you buy. Its nice
  for you if your real wage is high, provided that
  its not so high that you risk pricing yourself
  out of a job.

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• Similar considerations apply to Thailand. But in
  the case of Thailand, one of the main
  determinants of the RER is the amount of capital
  inflow.
• Capital inflow makes the RER appreciate. That is
  it makes Q fall. This is because capital inflow
  drives up domestic prices and makes the nominal
  exchange rate appreciate.

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• Capital inflow can be excessive. It is easy to
  tell after the event if capital inflow was
  excessive, but not at all easy to tell at the
  time.
• However, if capital inflow occurs because it is
  expected that the government will bail out
  domestic banks if private sector borrowers cant
  repay their bank debts, while the private sector
  borrowers will keep the profits if their projects
  succeed, then capital inflow will be excessive.
  The best response is to tackle the problem at
  source no bail-outs or, if that is not
  politically credible, tougher prudential controls
  on banks.