If positive inflation differentials occur and the exchange rate is fixed, the real exchange rate will appreciate. An appreciating exchange rate makes the country less competitive. However a flexible exchange rate acts as a buffer, a shock absorber, an automatic stabiliser. So if the inflation rates change there will be an equivalent change in the nominal exchange rate. This in turn leads to the real exchange rate remaining constant. As we learnt before, a change of the real exchange rate has an impact on the competitiveness of a country.
The price level in the country with the higher inflation will rise. So the nominal exchange rate multiplied with the foreign price level will lead to a higher numerator. However the domestic price level will still be as low as before (denominator). This means the higher numerator divided by the constant denominator will lead to a higher real exchange rate (see formula for real exchange rate)
Fixed exchange rate – no airbag, no shock absorber, no automatic stabiliser.
Real exchange rate moves instead of nominal exchange rate.
Price competitiveness falling (if positive inflation differential)
Price competitiveness rising (if negative inflation differential)
Flexible exchange rate – cushion, automatic stabiliser.
Nominal exchange rate moves, real exchange rate remains constant.
Price competitiveness stable / constant.
Real Exchange Rate:
Sreal = (Snominal * Pf ) / Pd
Snominal = nominal spot exchange rate (in American terms) (numerator 1/2)
Pf = foreign general price level in foreign currency (numerator 2/2)
Pd = domestic general price level in domestic currency (denominator (1/1))
Figure: Effect of real exchange rate on current account balance (CB)