Question

1. What is meant by the real exchange rate? What behaviors of the real exchange rate led economists to reject strong versions of PPP?

2. What is meant by a half-life? Why did Rogoff think half-lives are too long?

Answer 1

Real Exchange Rate

Real exchange rate compares the relative prices of two countries.(For example if we are talking about India and China,Real exchange rate refers to the relative prices of goods of India and China.Its the rate at which Indiand can trade their good for the goods produced by people of China)

The formula for calculating real exchange rate is as follows

Real exchange rate= E * P0/P1

P0=Domestic price leve

P1=Foreign price level

R=Nominal exchange rate

The rejection of ppp theory was caused due to the following factors

Ppp States that any change in the nominal exchange rate between two currencies is determined by relativei rates in those countries.This implies that real exchange rate remain constant over time.But all the empirical studies proved the opposite.

2.Half life of real exchange rate refers to the number of years required for the impulse response to a unit shock to dissipate one half.

Rogoff was of the opinion that half life is far too long to be explained by nominal rigidities ad it's difficult to rationalize slow adjustment if real shocks-sh ocks to taste and technology are predominant.