AP_Krugman_Textbook

Then the real exchange rate between the Mexican peso and the U.S. dollar is

defined as:

(42-1) Real exchange rate =Mexican pesos per U.S. dollar ×

To distinguish it from the real exchange rate, the exchange rate unadjusted for aggre-

gate price levels is sometimes called the nominalexchange rate.

To understand the significance of the difference between the real and nominal

exchange rates, let’s consider the following example. Suppose that the Mexican peso

depreciates against the U.S. dollar, with the exchange rate going from 10 pesos per

U.S. dollar to 15 pesos per U.S. dollar, a 50% change. But suppose that at the same

time the price of everything in Mexico, measured in pesos, increases by 50%, so that

the Mexican price index rises from 100 to 150. We’ll assume that there is no change

in U.S. prices, so that the U.S. price index remains at 100. The initial real exchange

rate is:

Pesos per dollar ×= 10 × = 10

After the peso depreciates and the Mexican price level increases, the real exchange rate is:

Pesos per dollar ×= 15 × = 10

In this example, the peso has depreciated substantially in terms of the U.S. dollar,

but the realexchange rate between the peso and the U.S. dollar hasn’t changed at all.

And because the real peso–U.S. dollar exchange rate hasn’t changed, the nominal de-

preciation of the peso against the U.S. dollar will have no effect either on the quan-

tity of goods and services exported by Mexico to the United States or on the

quantity of goods and services imported by Mexico from the United States. To

see why, consider again the example of a hotel room. Suppose that this room ini-

tially costs 1,000 pesos per night, which is $100 at an exchange rate of 10 pesos per

dollar. After both Mexican prices and the number of

pesos per dollar rise by 50%, the hotel room costs

1,500 pesos per night—but 1,500 pesos divided by

15 pesos per dollar is $100, so the Mexican hotel

room still costs $100. As a result, a U.S. tourist

considering a trip to Mexico will have no reason

to change plans.

The same is true for all goods and services that

enter into trade: the current account responds only to changes in

the real exchange rate, not the nominal exchange rate.A country’s products

become cheaper to foreigners only when that country’s currency depreciates in

real terms, and those products become more expensive to foreigners only when the cur-

rency appreciates in real terms. As a consequence, economists who analyze movements

in exports and imports of goods and services focus on the real exchange rate, not the

nominal exchange rate.

Figure 42.3 illustrates just how important it can be to distinguish between nominal

and real exchange rates. The line labeled “Nominal exchange rate” shows the number

of pesos it took to buy a U.S. dollar from 1990 to 2009. As you can see, the peso depre-

ciated massively over that period. But the line labeled “Real exchange rate” shows the

real exchange rate: it was calculated using Equation 42.1, with price indexes for both

Mexico and the United States set so that the value in 1990 was 100. In real terms, the

PUS

PMex

100

100

PUS

PMex

PUS

PMex

100

150

426 section 8 The Open Economy: International Trade and Finance

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