You may not have noticed, but the econocrats have raised the bar on the amount of economics you need to know to follow the debate about the economy - or, at least, to follow what they are saying about it. The jargon phrase of the year is the "real" exchange rate.
Until recently, heavies from Treasury and the Reserve Bank were content just to say the exchange rate - the overseas value of the Australian dollar - had depreciated (gone down) or appreciated (gone up) by a certain amount.
This was a reference to the "nominal" exchange rate - the one they tell you about at the end of a news bulletin, the one you can find in the business pages and the one your bank will use if you want to change some Aussie dollars into US dollars, euros or whatever.
As its name implies, the "real" exchange rate is the nominal exchange rate adjusted for inflation. But it's not just our inflation rate that comes into the calculation, it's our rate relative to the inflation rate of the country whose currency we're exchanging for the Aussie dollar.
Actually, just to complicate it a bit further, when economists talk of the real exchange rate, they're usually referring to the real "effective" exchange rate. This is our exchange rate, not against the US dollar or any other particular currency, but against all the currencies of our major trading partners, with each partner's currency weighted according to that country's share of our two-way (exports plus imports) trade. In other words, our effective exchange rate is the trade-weighted index.
(Of the 22 currencies in the trade-weighted basket, the Chinese yuan gets a weight of almost 23 per cent, then the yen with 15 per cent, the euro with 10 per cent, the US dollar on 9 per cent, South Korean won on 6 per cent, India rupee on 5 per cent and so on.)
Whether they talk about the nominal exchange rate or the real exchange rate, economists always think in terms of the real exchange rate because they believe it's always real (inflation-adjusted) variables that matter.
It's the real growth in gross domestic product that's important, and real interest rates and real wage rates that influence people's behaviour. (When people pay too much attention to nominal variables, they're said to be suffering from "money illusion".)
Let's assume the nominal effective exchange rate stays stable for a period. If our inflation rate is higher than the average inflation rate of our trading partners, the real exchange rate is appreciating.
If our inflation rate is lower than the average for our trading partners the real exchange rate is depreciating.
Why? Because they are the adjustments necessary to ensure the prices of internationally traded goods and services end up being the same in all countries, as predicted by the theory of "purchasing power parity" (PPP) - economists' main theory about what determines the way exchange rates move.
When economists say a particular currency is overvalued by X per cent, or undervalued by Y per cent, it's the assumption of PPP they're using as the basis for their calculation. But the fact that economists are always making such calculations is a reminder that the actual market exchange rate of a currency can go for years being significantly at variance with where the PPP theory says it should be.
So if PPP holds in the real world, it can only be said to hold over the long term. In the shorter term, lots of other factors affect the way exchange rates move.
However, if we stick to the theory and assume there's an inexorable, "equilibrating" force (a force that moves everything towards equilibrium, or balance) moving every currency towards PPP, then countries that don't allow their currencies to float freely - by, for instance, fixing their currency to that of another country - will find their inflation rate adjusting to move their real exchange rate in required direction.
Thus if you're holding your currency's value too low (according to PPP), you'll end up with an inflation rate that's a lot higher than your trading partners' rates, which will cause your real exchange rate to appreciate. Many economists would say this is China's problem at the moment.
All this is great fun if you like fancy analysis (as economists do), but does it matter? It matters to the economy - and to a lot of business people - because our real effective exchange rate is the best measure of the "international competitiveness" of our export and import-competing industries.
And thanks to the huge appreciation in the nominal exchange rate brought about by the foreign exchange market's response to the sky-high prices we're getting for our coal and iron ore, our real effective exchange rate is the highest it's been since the mid-1970s and about 40 per cent higher than its average since the dollar was floated in 1983. In other words, it's a long time since our tradeables industries were less competitive internationally than they are today. This isn't a great problem for our miners, because the world prices they're getting are so high at present, nor is it a great problem for our farmers, whose prices for many items are high, too.
But it is a big problem for our manufacturers and the producers of our two biggest services exports: tourism and education. Actually, both manufacturing and tourism are import-competing industries as well as export industries. They're getting wacked.
Remember this, however: because economists are so obsessed by prices, they often forget to make it clear they're talking about international price competitiveness. When you're exporting undifferentiated, bulk commodities - whether mineral or agricultural - price competition is the main game.
But for more sophisticated products, there's plenty of non-price competition. You can compete on quality, stylishness, reputation, reliability, service and so forth. You can cater to niche markets the big boys don't bother with. Such "business models" can allow you to have higher prices and still make sales.
Since there's nothing sensible the authorities can do to lower our exchange rate - real or nominal - and since it looks likely to stay high for many moons, the more our hard-pressed tradeables industries focus on non-price competition, the better they'll survive.
