Question

6. An examination of the record of real exchange rates after the end of the Bretton Woods fixed exchange rate system in 1973 shows an increase in their variability, which is due to fluctuations in nominal exchange rates. What does this record imply for purchasing power parity?

7. Countries with strong growth rates due to higher productivity generally have appreciating real exchange rates. Why would higher levels of national income result in a real currency appreciation?

8. Compare the impact of a rise in domestic income on the exchange rate in the balance of payment flow and monetarist models of exchange rates. Explain your answers.

Answer 1

Answeringonly the first one as these are separate independent questions.

6) Variability increased because currencies were allowed to float. However, these fluctuations were in nominal exchange rates. Purchasing power parity normalises for nominal exchage rates and looks at whether the analysed currency (like GBP) can buy the same amount of goods and services as that of subject currency (like USD).

However, fluctuation in nominal rates could have happened even with PPP staying constant. It could have been only due to over/under valuation of one of the currencies. In longer run, if the flucuation continues that would mean PPP itself was not constant.

7) Though it is said that higher national income means more demand for imports and therefore a decline in the exchange rate. However, if the growth has happened on the back of a strong export record like that of China, then we would say that currency appreciation has happened because of that.