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Relative Strenght Analysis

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1. Explain the following concepts with necessary examples and outline their importance for an economy: nominal exchange rate, real exchange rate, nominal effective exchange rate, real effective exchange rate

EXCHANGE RATE :

An exchange rate is the current market price for which one currency can be exchanged for another.

NOMINAL EXCHANGE RATE:

It is defined as the actual foreign exchange quotation in contrast to the real exchange rate, which has been adjusted for changes in purchasing power.

MATHEMATICAL FORMULATION :

The nominal exchange rate e is the price in domestic currency of one unit of a foreign currency.

e.Pi=Pi*

Here:
• e denotes the nominal exchange rate of the domestic currency in terms of the foreign currency
• pi denotes the price of good i in domestic in domestic currency
• e.pi is the price of the same good in domestic in foreign currency
• *pi denotes the price of the same good in the foreign in foreign currency

REAL EXCHANGE RATE:

Basically, the real exchange rate can be defined as the nominal exchange rate that takes the inflation differentials among the countries into account. Its importance stems from the fact that it can be used as an indicator of competitiveness in the foreign trade of a country.

The Real Exchange Rate Definitions

The various definitions of the real exchange rate can mainly be categorized under two main groups. The first group of definitions is made in line with the purchasing power parity. The second group of definitions, on the other hand, is based on the distinction between the tradable and the non-tradable goods.

Purchasing Power Parity

According to this definition, the real exchange rate can be defined in the long run as the nominal exchange rate (e) that is adjusted by the ratio of the foreign price level (Pf) to the domestic price level (P). Mathematically, it can be shown

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