What happened to Pakostani real exchange rate when pakistani nominal exchange rate is unchanged but prices rise faster than the abroad
Answers
Answer:
Explanation:
At this point we must recognize that the economy we are analyzing is part of a larger world and examine the relationship between the price level and the exchange rate. The exchange rate is the price of foreign money in units of domestic money or, under an alternative definition, the price or value of domestic money in units of foreign money. It is of fundamental importance because every time domestic residents want to buy something abroad they must exchange domestic currency for foreign currency, and every time foreigners want to buy domestic goods they must exchange foreign currency for domestic currency.
The exchange rate has an important relationship to the price level because it represents a link between domestic prices and foreign prices. For example, ignoring taxes, subsidies and shipping costs, the price of wheat in Canada must equal the exchange rate (price of the U.S. dollar in terms of the Canadian dollar) times the U.S. dollar price of wheat. For a commodity, call it x , that is traded internationally, we can thus write
1. Px = Π P*x
where Px is the domestic price (in domestic currency), P*x is the price abroad (in foreign currency) and Π is the exchange rate (price of foreign currency in units of domestic currency). This relationship is called the law of one price.
If every good produced in the domestic economy is also produced in the foreign economy, and if the shares of each good in aggregate output are the same in both economies, then the domestic price level will equal the exchange rate times the foreign price level.
2. P = Π P*
where P and P* are the domestic and foreign price levels. It follows, then, that if there is inflation in the domestic economy, not matched by inflation abroad, so that P rises relative to P*, the exchange rate Π (domestic currency price of foreign currency) has to rise---that is, the domestic currency must depreciate in terms of foreign currency.
Suppose that the government decides to fix the price of its currency in terms of some foreign currency---that is, adopt a fixed exchange rate. In this case, Π in Equation 2 will be fixed at some level, say, Π0. If the price level in the foreign country happens to P*0, the domestic price level will be fixed at
3. P0 = Π0 P*0.
As we can see from Figure 1, this will require that the domestic money supply be fixed at M0. By fixing the exchange rate, the domestic authorities tie their hands with respect to monetary policy---they are forced to create a specific equilibrium nominal money supply. As a matter of policy, the government can control either the domestic money supply or the country's exchange rate but not both.