Net External Wealth and Real Exchange Rate Essay

Net External Wealth and Real Exchange Rate - Essay Example If the value of currency of a nation appreciates, then the value of its indebtedness in terms of foreign assets falls. This helps to improve the nations NFA situations and vice versa (Williamson, 2008). The nominal exchange rate (e) explains the amount of home currency (units) that can be purchased with a given unit of a foreign currency. Thus a rise in e refers to the depreciation or devaluation of the currency of a nation. On the other hand, the fall in e refers to the appreciation or evaluation of the currency of a nation. Real exchange rate is defined as the simple ratio of the price level (Pd) of the domestic currency and the price value of the foreign currency (Pf ). The real exchange rate of a nation (Q) = Pd/e*Pf , It refers to the amount of goods and services of a domestic country that can be purchased by a unit of money of a foreign nation (CNB, 2013). When analysts assess the changes in the exchange rates in the international trade, they rely more on the real exchange rate than nominal exchange rate. A real appreciation refers to a rise in the real exchange rate while a nominal appreciation refers to a decrease in the nominal exchange rate (Feenstra and Taylor, 2008). Relationship between Net Foreign Asset and Real Exchange Rate The relationship existing between the net foreign assets of a country and the real exchange rate has been a debatable issue of concern since 1920. If a steady state open economy model is considered, then the following relations can be established: tb = -r*b (1) (States that a steady trade deficit can exist in a nation = net investment income on net foreign asset position). rer = -Otb + ?X (2) (States that if the other factors in the economy (X) are... This paper stresses that the net external wealth of a nation relates to the balance of payment conditions of the country. The net foreign asset of a nation is the difference of the value of the asset owned by the nation from the rest of the world and the value of the asset of the country owned by the foreign countries in the world. The changes in the exchange rates of a nation largely influence the values of its foreign assets and liabilities. If the value of currency of a nation appreciates, then the value of its indebtedness in terms of foreign assets falls. This helps to improve the nations NFA situations and vice versa. When analysts assess the changes in the exchange rates in the international trade, they rely more on the real exchange rate than nominal exchange rate. A real appreciation refers to a rise in the real exchange rate while a nominal appreciation refers to a decrease in the nominal exchange rate. This report makes a conclusion that the traditional belief that the real exchange rate and NFA is inversely related is no longer feasible in the modern era, after the occurrence of globalization. A country in its economy can now always afford to encourage foreign direct investment and augment the level of its NFA. This is due to the fact that though the extent real exchange rate or currency value of the country would fall in the short run, the positive returns from the investments in the long run would substantially help the nation improve its real exchange rate. Therefore post-globalization, real exchange rate is assumed to have a positive relationship with NFA