As illustrated previously the distinction between a real and nominal -currency-rate change is important.It matters to managers because nominal-rate changes do not necessarily alter corporate competitive positions,but real ones do.In addition,the distinction is important to government economic policy and tactics.As we shall see for example ,it is not clear whether governments can cause lasting real-exchange-rate movement by forcing changes in the nominal rate.A nominal -rate change by definition,is offset by the inflation differential between the currencies and therefore, will not do much to help with a trade deficit.We will look at these issues shortly.First,though we will look at what actually happened to exchange rates in the period 1974-1990,both real and nominal,for some of our more widely traded currencies.
In all cases , the consumer price index was the measure of inflation used to calculate the real exchange rate from the nominal one.
Real exchange rates are the nominal rates adjusted for inflation since our arbitrary starting point in 1974.For example,in early 1974 it took less than .98 Canadian dollars (CAD) to buy one U.S dollar.
Ten years later,the nominal had moved to 1.28 CAD/USD .However,cumulative inflation in the decade was 140 percent in Canada,but only 166 percent in the United States.Adjusting the nominal 1984 rate(relative to the .98 CAD/USD rate in 1974)of 1.15 CAD/USD, as follows:
1.28 x (2.16/2.40) = 1.15
There was therefore , a real-exchange -rate adjustment in the period of about 17 percent:
(1.15-.98)/.98=.174
It took 17 percent more Canadian goods to buy the same quantity of U.S goods in 1984 compared to 1974.The terms of trade (the price of foreign goods in terms of domestic goods)changed,together with the relative competitiveness of Canadian and American firms(abstracting from productivity changes)as well as the relative wealth of Canadians and Americans.Note th
at the change in the nominal exchange rate was much greater that 17 percent.It was actually 31 percent [(1.28-.98)/.98],but almost half of this nominal move was offset by the higher rate of inflation in Canada.
Patrick Abboud
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