First, you need to understand that the real exchange rate can be thought of as the
price of one countrys basket of goods relative to another countrys basket of goods at
a particular point in time. by basket of goods, i mean the price of an unchanging
basket of goods containing typical weekly purchases by a countrys typical household.
When the nominal exchange rate rises by 5% and we want to know the effects of this
change on the price of canadas goods relative to goods in the us, we take into
account the inflation rate of both countries (thus giving us changes in the real
The textbook shows that after considering the nominal exchange rate increase of 5%,
and also considering the inflation rate of 2% in canada and 5% in the us, we discover
that the real exchange rate is approximately 2% by carrying out the following
(5% cdn$ + 2% cdn inflation) - 5% us inflation.
Consider what would happen if the cdn$ rose by 5%, canadian inflation was 0% and
us inflation was 5%.
If the cdn$ is up 5%, that means that it costs the us 5% more to purchase canadian
goods. However, since the us inflation rate is also higher by 5%, its more expensive
for americans to by us goods as well. In comparing the basket of goods from canada
versus the united states, relatively speaking there has been no real change:
(5% cdn$ + 0% cdn inflation) - 5% us inflation = 0%.
Now consider what would happen if the cdn$ was up by 5% and inflation in canada
was up by 2% but inflation in the us was 0%.
If the cdn$ rises by 5%, that means that it costs the us 5% more to purchase
canadian goods. But because the price of cdn goods have also increased, its even
more expensive than one might first realize, considering the fact that us prices
remained the same:
(5% cdn$ + 2% cdn inflation) - 0% us inflation = 7%
from this you can intuitively see that the price of a basket of goods in canada has
risen 7% relative to the price of a basket of goods in the us.