Real vs. nominal exchange rates

by on October 25, 2010 at 12:34 pm in Economics | Permalink

Ed Dolan writes:

In nominal terms, the yuan has strengthened about 2.5% since China's June 19 decision to ease its currency policy. That works out to an annualized rate of nominal appreciation of almost 8%. The simplest way to calculate real appreciation is to add on the difference between China's inflation rate (3.5%, according to August data) and US inflation (about 1%, or even less if the dip in the September figures holds up). Doing so gives us an annual rate of real appreciation of more than 10%. Two or three years of that would pretty well eliminate the 20 to 40% undervaluation that critics are talking about.

I would stress the point that the general rate of inflation is not the ideal measure here (what is the inflation rate for tradeables or would-be tradeables?), but the point remains an important one.

1 BPO October 25, 2010 at 9:41 am

Why are virtually no economists or financial analysts discussing this? If this is the "right" way of looking at the issue, why would the U.S. be pressuring China to the extent that it is (I don't buy that it's just to gain votes), and why wouldn't China be trumpeting this very loudly (as they like to do any time they feel they've got something to trumpet in their defense)?

2 nelsonal October 25, 2010 at 10:24 am

Isn't the difference in inflation rates supposed to be the change in the exchange rate?

3 Hoosier October 25, 2010 at 12:27 pm

I'm confused like M. My textbooks all would seem to say the opposite. Can anyone be so kind as to clear this up?

4 Hoosier October 25, 2010 at 12:54 pm

In your example, is not the real exchange rate of the dollar rising, not the yuan?

5 Matthew October 25, 2010 at 1:21 pm

It is a little bit confusing. The change in the nominal exchange rate means that a dollar can buy fewer Yuan. Also, the yuan inflation relative to dollar inflation means that those Yuan can buy fewer goods than the same number of yuan before the inflation. The result is that basket X of real American goods can now only buy a smaller basket Y of Chinese goods. Conversely, for the Chinese they now need only a smaller basket Y to buy the same basket X. I agree it's confusing to say the yuan appreciates, because a given number of yuan may only buy a smaller basket of goods because of the yuan inflation. But if you look at it in terms of real goods and services it makes sense.

Personally, it seems like the change in real exchange rates in this scenario is a bad thing not a good thing for the US, but most people seem to thing it's a good thing.

6 Ed Dolan October 25, 2010 at 9:10 pm

Sunset Shazz–Thanks for that great link.

BTW, Tyler is right, it would be even better to calculate the real exchange rate using unit labor cost (change in nominal wages adjusted for change in productivity). I didn't use ULC because I can't find an up to date data series for China. Can anyone out there who knows Chinese stats better than I do tell me where to find that data? In the US, the BLS reports ULC fell at the remarkably fast rate of -8% in Q1 2010 and -5.9% in Q2 2010. Meanwhile China news is full of strikes and big wage settlements at leading exporters, so I suppose their ULC is going up (I am guessing–but it is just a guess–that wages are rising faster than productivity is increasing). If so, the change in ULC deflated real exchange rate would be even more than than the CPI deflated real rate.

Some of the comments on this thread illustrate my point yesterday–the real exchange rate concept is real hard to popularize. The instinctive reasoning is "depreciation is bad, inflation is bad, so inflation must cause depreciation." In the context of a floating exchange rate, there is something to that reasoning, because inflation will cause your nominal exchange rate to depreciate in order to keep the relative competitiveness of your exports (the real exchange rate) about the same. But here we are looking at a different case, because China does not have a floating exchange rate. Think of it this way as applied to the Chinese case: Inflation in China, taken by itself, makes China's exports less competitive on international markets. Nominal appreciation of the yuan, by itself, also makes Chinese exports less competitive, so nominal appreciation plus inflation makes them even less competitive. That is why the combination is called "real appreciation."

7 ek1029 October 26, 2010 at 12:50 am

What he is saying is that each USD buys less RMB and each RMB has less purchasing power in CN which means that each USD effectively can buy less CN goods. Thus an appreciation of the RMB. I got caught up in the wording too.

8 organic baby product October 28, 2010 at 7:06 am

Real exchange rate can be defined as the rate that takes into account inflation differential between the countries. Central banks use the concept of real effective exchange rate to adjust nominal effective exchange rate for inflation.

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