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Lesson M10.L01: Exchange Rates ā€” Nominal, Real, and Effective

Module: Exchange Rates and the Open Economy Level: intro Duration: 30 minutes Learning Objective: Distinguish nominal, real, and trade-weighted effective exchange rates using AUD/USD and RBA TWI data. Data as of: 2024 Provenance: RBA Education | OpenStax Macro 3e

Explanation

An exchange rate is the price of one currency in terms of another. There are three related but distinct concepts:

1. Nominal exchange rate (e): The rate at which two currencies trade. For Australia, the most watched rate is AUD/USD ā€” the number of US dollars one Australian dollar buys. For example, if AUD/USD = 0.65, then A$1 buys US$0.65.

2. Real exchange rate (q): Adjusts the nominal rate for relative price levels between countries:

q = e Ɨ (P*/P)

where e is the nominal AUD/USD rate, P* is the US price level, and P is the Australian price level. If the AUD appreciates nominally (e rises) but Australian inflation is higher than US inflation, the real appreciation may be smaller. The real exchange rate measures international competitiveness ā€” a higher q means Australian goods are relatively more expensive to foreigners.

3. Trade-Weighted Index (TWI): Australia trades with many countries, not just the US. The RBA publishes a Trade-Weighted Index ā€” a weighted average of the AUD against the currencies of Australia's major trading partners (China, Japan, US, South Korea, EU, etc.), with weights based on trade volumes. The TWI gives a broader picture of Australian competitiveness than the bilateral AUD/USD alone.

As of 2024, Australia's major trading partner China accounts for around 28% of exports, making the AUD sensitive to Chinese economic conditions and iron ore demand. The RBA's TWI is indexed with a base of May 1970 = 100.

Worked Example

Scenario: Calculate the real AUD/USD exchange rate.

Given data (approximate, 2024): - Nominal AUD/USD exchange rate: e = 0.65 (A$1 = US$0.65) - Australian CPI (P): 130.0 (base year = 100) - US CPI (P*): 118.0 (base year = 100, same base)

Step 1 ā€” Apply the real exchange rate formula:

q = e Ɨ (P*/P) q = 0.65 Ɨ (118.0 / 130.0)

Step 2 ā€” Calculate the price ratio:

P*/P = 118.0 / 130.0 = 0.9077

Step 3 ā€” Calculate q:

q = 0.65 Ɨ 1.1017 = 0.7161

Interpretation: Despite the nominal depreciation (e = 0.65 vs base 0.70), Australia's higher inflation (P rose from 100 to 130 vs US 100 to 118) means Australian goods are actually more expensive in real terms. The real exchange rate q = 0.716 is above the base value of 0.70 ā€” a real appreciation of 2.3%. The nominal depreciation has been more than offset by the inflation differential.

Step 4 ā€” Compare to a baseline year:

Suppose in the base year: eā‚€ = 0.70, Pā‚€ = 100, P*ā‚€ = 100 ā†’ qā‚€ = 0.70 Ɨ (100/100) = 0.70

Real AUD has appreciated: q rose from 0.70 to 0.716, a rise of (0.716 āˆ’ 0.70)/0.70 Ɨ 100 = +2.3%. Despite the nominal depreciation (e fell from 0.70 to 0.65), higher Australian inflation made Australian goods more expensive in real terms.

Despite some nominal depreciation, Australian goods are more competitive relative to the base year.

Common Misconception

Misconception: "If the AUD/USD falls (the AUD depreciates), Australian exports automatically become more competitive."

Correction: Nominal depreciation improves competitiveness only if Australian inflation does not fully offset the exchange rate movement. The real exchange rate q = e Ɨ (P*/P) is what matters for trade competitiveness. If Australia has 5% inflation while the US has 1%, a 4% nominal depreciation leaves the real exchange rate almost unchanged ā€” no competitiveness gain. The TWI similarly needs to be compared to relative inflation rates across all trading partners.

Practice Prompts

  1. Why does the RBA publish a Trade-Weighted Index (TWI) in addition to the bilateral AUD/USD exchange rate? ā†’ Answer: The TWI provides a broader measure of the AUD's value against the currencies of all major trading partners, weighted by trade volumes. Since Australia trades heavily with China, Japan, South Korea, and the EU (not just the US), the AUD/USD alone can be misleading. For example, if the AUD depreciates against the USD but appreciates against the CNY and JPY, the net competitive impact depends on trade weights ā€” which only the TWI captures.

  2. NUMERICAL CALCULATION: The nominal AUD/USD rate is 0.68. Australia's CPI is 140.0 and the US CPI is 120.0 (both relative to the same base). Calculate the real exchange rate q and determine whether Australian goods are more or less competitive than the nominal rate implies. ā†’ Answer: Step 1: q = e Ɨ (P/P) = 0.68 Ɨ (140.0/120.0) Step 2: P/P = 140.0/120.0 = 1.1667 Step 3: q = 0.68 Ɨ 1.1667 = 0.7933 Interpretation: The real exchange rate (0.5828) is substantially below the nominal rate (0.68). Australia's higher price level (relative to the base) means Australian goods are less competitive than the nominal rate alone implies. Foreign buyers get less purchasing power for their money when buying Australian goods.

  3. Australia's AUD/USD rate rises from 0.62 to 0.75 over two years while Australian inflation outpaces US inflation. A news headline reads: "Strong AUD will hurt Australian exporters." Is this necessarily true? ā†’ Answer: It depends on the real exchange rate. A nominal AUD appreciation (e rises from 0.62 to 0.75) makes Australian goods more expensive in USD terms, hurting exporters. However, if Australian inflation also rises significantly relative to the US, the real exchange rate may rise less (or not at all). Exporters care about the real exchange rate ā€” their Australian production costs relative to the foreign currency price they receive. If Australian wages and inputs have also risen sharply, the competitiveness loss is confirmed; if not, nominal appreciation may not fully translate to reduced competitiveness.

Further Resources