Question

Explain how the nominal euro/RMB exchange rate would be affected (all else equal) by permanent changes in the expected rate of real appreciation of the RMB against the euro.

Short answer

If the RMB is expected to appreciate in real terms against the euro, demand for RMB would increase, causing an increase in the value of RMB relative to the euro. This would lead to a decrease in the nominal euro/RMB exchange rate, meaning fewer RMB would be required to purchase one euro.

Step-by-step solution

Understanding Exchange Rates

An exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country's currency in relation to another currency. The nominal exchange rate specifically refers to the current value, without adjustments for inflation or other factors.

Expected Rate of Real Appreciation

The expected rate of real appreciation of a currency refers to the expectation that the value of the currency will increase in real terms over time, compared to another currency. This takes into account not just nominal exchange rates, but also differences in relative price levels or inflation rates between two countries.

Impact of Expected Real Appreciation on Nominal Exchange Rate

If the RMB is expected to appreciate in real terms against the euro, it implies that the future purchasing power of RMB is expected to increase relative to the euro. Investors and traders will see the RMB as more valuable in the future, increasing demand for RMB in the present. As a result, the nominal exchange rate will adjust because as demand for RMB rises, its value will go up relative to the euro. Hence, the nominal euro/RMB exchange rate will decrease, as fewer RMB will be needed to buy one euro.

Key concepts

Nominal Exchange Rate

The nominal exchange rate is the starting point for any discussion on currency conversion and international economic comparison. It represents the current value of one currency against another in the global market. For instance, if you were to exchange euros for Chinese renminbi (RMB), the nominal exchange rate would dictate how many RMB you'd receive for each euro. Unlike real exchange rates, nominal rates don't consider the complexities of purchasing power or inflation differentials. They are the 'sticker price' of currency exchange.
To bridge this concept to a real-world scenario, let's assume you're planning a trip to China from Europe. The nominal exchange rate will determine how much RMB you can get for your euros at the currency exchange booth. This rate constantly fluctuates due to factors like trade flows, interest rates, and market sentiment. However, it is essential to remember that the nominal rate is a snapshot in time, much like a quote for a stock price, reflecting the immediate value of one currency in terms of another.

Expected Rate of Real Appreciation

Shifting our focus toward the future, the expected rate of real appreciation involves predictions and market sentiment about a currency's value over time. This concept transcends the nominal exchange rate by considering the expected changes in a currency's purchasing power relative to another currency. Currency appreciation, in real terms, would mean that one can buy more goods and services with the same amount of money over time.
For example, if analysts predict that the RMB will experience real appreciation against the euro, it suggests that the RMB's value in terms of goods and services it can buy will increase over the coming years. This expectation can create immediate consequences in the financial markets. Investors may start to buy RMB in anticipation of this appreciation, and such increased demand can influence the nominal exchange rate even before any actual changes in purchasing power materialize.

Currency Appreciation

When exploring the realm of currency appreciation, we delve into the gain in value of one currency relative to another. Currency appreciation can happen for various reasons, including higher interest rates attracting foreign investment, economic growth, or a trade surplus. Appreciation results in more expensive exports and cheaper imports for the appreciating currency's economy.

How It Affects Consumers and Businesses

For consumers in the country with the appreciating currency, foreign products become more affordable, potentially increasing demand for imported goods. Conversely, domestic companies that rely on exporting their goods may find it harder to compete on price, as their products become costlier for foreign buyers. It's a delicate balance that can have a substantial impact on international trade and economic health.

Inflation Rates

Inflation rates play a crucial role in the context of exchange rates and currency values. Inflation signifies the rate at which the general level of prices for goods and services is rising, subsequently eroding purchasing power. Central banks closely watch inflation to manage monetary policy effectively.
When a country experiences higher inflation, its currency typically depreciates against currencies with lower inflation rates because each unit of currency buys fewer goods and services over time. This is a vital consideration for long-term investors and businesses that operate internationally. Steady and predictable inflation is often a sign of a healthy economy, whereas hyperinflation or deflation can signal economic distress. Understanding how inflation impacts exchange rates is fundamental for predicting currency movements and making informed economic decisions.