It is now generally accepted that the real exchange rate is a
key relative price in an econom/ Changes in the real exchange rate
influence foreign trade flows, balance of payments, the structure and
level of production, allocation of resources, etc. While the real
exchange rate is an endogenous variable that responds to both exogenous
as well as policy-induced shocks, the nominal exchange rate is usually
taken as a policy instrument. The two rates, however, are found to be
related to each other. 2 For effective policy-making, it is imperative
to have some idea about different factors that influence the real
exchange rate. Equally important is the knowledge of the manner in which
the real exchange rate responds to changes in the exogenous variables.
While there is a general consensus that the impact of various exogenous
shocks on the exchange rate is transmitted through four broad channels,
namely, (i) absolute prices, (ii) relative prices, (iii) income, and
(iv) interest rates, the relative importance of each of these channels
is found to vary across countries. In general, it depends on the degree
of openness of the economy and the relative effectiveness of the fiscal
and the monetary sectors within a country.
The Real Exchange Rate, Real Interest Rates, and the Risk Premium