Question

Answer the following on real exchange rate:

A) With the slowing of the global economy, especially in China, the demand for key commodities (e.g. oil, iron ore, coal) has declined significantly and so have their price. In this backdrop, the real exchange rate of the Australian dollar has depreciated significantly, mainly on the back of the depreciation of the nominal exchange rate (i.e., weaker AUD). Shouldn’t the Australian central bank be worried about this? Doesn’t this reflect a massive loss in confidence in Australia?

Answer 1

Real Exchange rate is calculated as: Nominal Exchange rate * (Domestic Price / Foreign Price)

If there is fall in demand of Chinese goods which resulted in fall in price of them. Chinese goods and foreign goods for Australia which means foreign price have decreased.

Additionally nominal exchange rate of Australia have also reduced which results in fall in real exchange rate. If Nominal exchange rate have reduced and foregn price have reduced, reduction in nominal exchange rate dominates the reduction in foreign price because reduction in foreign price alone tends to raise the real exchange rate. In total as real exchange rate have reduced, there will be rise from net exports from Australia because Austrlian goods are comparatively cheaper than Chinese goods. Central bank should not worry about this as it would improve trade deficit. If Australian companies are able to win consumers heart with their quality and pricing, there will be more confidence in Chinese economy.