Currency Strategy – The Practitioner’s Guide to Currency Investing, Hedging and Forecasting : [PDF Download]

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“The real exchange rate is a function of the price or inflation differential and the nominal exchange rate. The relationship between the concept of PPP and the “real exchange rate” – or the nominal exchange rate adjusted for price differentials – is of necessity a close and important one.

In line with this relationship is the core idea that if PPP is seen to hold over the long term, then the real exchange rate should remain constant. This is the case because if PPP holds relative price differentials between two countries will over the long term be offset by an appropriate nominal exchange rate adjustment.

Granted, the real exchange rate may fluctuate significantly over the short term, with the result that such fluctuations can have potentially important economic impact, however, it should revert to mean over time assuming PPP holds.

When the real exchange rate is constant, the international price competitiveness of a country’s tradable goods is maintained. Another way of expressing this is to say that when a country experiences high inflation, its tradable goods become proportionally uncompetitive.

In order to restore price competitiveness, there has to be a depreciation of the nominal exchange rate. In order to gain competitiveness, a country needs a real depreciation, not simply depreciation in the nominal value of the exchange rate.”

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