Let us make an in-depth study of the Determinants of the Real Exchange Rate.
1. The BOT (NX) is equal to net capital outflow, which, in turn, equals S-I.
2. Saving (S) depends on C, G and T.
3. Investment (I) depends on both the domestic and the world rate of interest. In a world of perfect capital mobility, there is only one rate of interest.
ADVERTISEMENTS:
Fig. 6.5 shows how the RER is determined. The NX (er) curve is downward sloping for a simple reason. This has already been explained. The line S – I, showing the excess of saving over investment, is vertical because there is no relation between S or I and the RER. The net export curve intersects the vertical S-I curve at point E and the equilibrium rate of exchange is er0.
The two curves in Fig. 6.6 may be interpreted as the supply and demand curves for foreign exchange. The vertical line S – I, represents the net capital outflow and thus, the supply of pounds to be exchanged into dollar (or any other foreign currency) and invested in USA (or abroad).
The downward sloping curve, NX, represents the net demand for pounds by foreigners who want pounds to buy British goods. At the equilibrium RER (er0), the supply of pounds available for the net capital outflow balances the demand for pounds by foreigners buying British goods (i.e., its net exports).
