Question

What happens to the real exchange rate if the nominal exchange rate can’t adjust ?
(because Denmark and EU have agreed to a fixed exchange rate system.

Answer 1

If the nominal exchange rate can't adjust ( as Denmark and the EU have agreed to a fixed exchange rate system ) we will observe

• A misalignment between the real exchange rate and the nominal exchange rate

Therefore, the real exchange rate will not truly reflect purchasing power parity.

In this case, the real exchange rate will get either

• Either undervalued or overvalued depending upon the relative state of the economies existing in both the economies

1st case

For example, say for the USA and the UK the nominal exchange rate is fixed at -

• 1 Pound = 1.3 US Dollars

Also, 1000 Pound in the UK is able to buy 1300 US Dollar worth of goods in the USA

Hence, the real exchange rate of the USA and the UK is also -

• 1 Pound = 1300 divided by 1000 = 1.3 US Dollars

Therefore, the real exchange rate reflects the purchasing power parity.

2nd case

Now, if there is inflation in the USA,

Here, let's say that the same 1300 US Dollar worth of goods say costs   1600 US Dollar

Hence, the real exchange rate of the USA and the UK is now -

• 1 Pound = 1600 divided by 1000 = 1.6 US Dollars

But, the USA and the UK the nominal exchange rate is fixed at -

• 1 Pound = 1.3 US Dollars

Therefore, the real exchange rate is not reflecting purchasing power parity.

• It is because 1000 Pound in the UK is not able to buy the exact same amount of goods in the USA
• Here, we will be 300 Dollars short while buying the exact same amount of goods in the USA

Therefore, we can say that

• The Pound is undervalued against the US Dollars
• We can also say that the US Dollars is overvalued against the Pound

Therefore, if the nominal exchange rate can't adjust the real exchange rate then

• A misalignment between the real exchange rate and the nominal exchange rate
• Therefore, the real exchange rate   will either get undervalued or overvalued   
• Hence, the real exchange rate will not truly reflect purchasing power parity.