Real Exchange Rate

Published Sep 8, 2024

Definition of Real Exchange Rate

The real exchange rate (RER) is a measure that adjusts the nominal exchange rate to reflect differences in price levels between two countries. It shows the relative price of goods between countries and is crucial for understanding competitiveness and purchasing power. In essence, the real exchange rate helps to determine how many goods and services can be exchanged between two countries beyond just looking at the currency values.

Example

Consider the nominal exchange rate between the United States and Japan. Assume 1 USD is equivalent to 100 JPY. If a basket of goods costs $200 in the U.S. and the same basket costs 20,000 JPY in Japan, the real exchange rate can be calculated as follows:

1. First, determine the nominal exchange rate: 1 USD = 100 JPY.
2. Second, compare the price levels: the U.S. basket costs $200, and the Japanese basket costs 20,000 JPY.
3. Finally, calculate the RER: RER = Nominal Exchange Rate * (Price Level in home country / Price Level in foreign country) = (100 JPY/USD) * (200 USD / 20,000 JPY) = 1.

A real exchange rate of 1 indicates purchasing power parity (PPP), meaning goods cost the same amount in both countries when priced in a common currency. If the result were different, it would reflect a disparity between the actual cost of goods and the nominal exchange rate.

Why Real Exchange Rate Matters

The real exchange rate is vital for several reasons:

• Competitiveness: It indicates how competitive a country’s goods and services are globally. A lower RER means that domestic goods are cheaper compared to foreign goods, enhancing export competitiveness.
• Inflation Adjustment: Helps to account for inflation differences between countries, providing a more accurate picture of the actual value of currencies.
• Trade Balance: Influences the trade balance by affecting export and import prices, which in turn impacts economic growth.
• Investment Decisions: Real exchange rates provide valuable information for investors looking to diversify portfolios internationally. They can signal when assets in one country are undervalued relative to another.

Frequently Asked Questions (FAQ)

How does a change in the nominal exchange rate affect the real exchange rate?

A change in the nominal exchange rate directly impacts the real exchange rate, but not in isolation. If the nominal exchange rate for USD to JPY rises from 100 JPY to 110 JPY, USD appreciates relative to JPY. However, if price levels also change, it complicates the effect on the RER. The real exchange rate will reflect these changes by adjusting for the inflation rate difference between the two countries. Therefore, a nominal appreciation must be evaluated alongside domestic and foreign price level changes to understand its true impact.

What role does purchasing power parity (PPP) play in understanding the real exchange rate?

Purchasing Power Parity (PPP) is a crucial concept for understanding the real exchange rate. It posits that in the long run, the exchange rate between two currencies should move toward levels that equalize the price of an identical basket of goods and services in any two countries. If the real exchange rate deviates significantly from 1, it suggests that one currency is under or over-valued. Using PPP helps in identifying these discrepancies and provides a basis for predicting long-term exchange rate movements.

How can government policies affect the real exchange rate?

Government policies can significantly influence the real exchange rate through various mechanisms:

• Monetary Policy: Central banks affecting interest rates can alter inflation rates, impacting the real exchange rate.
• Fiscal Policy: Government spending and taxation decisions can drive economic activity and price levels, thus affecting RER.
• Currency Interventions: Direct interventions in the foreign exchange market to stabilize or change the nominal exchange rate reflect on the RER when adjusted for price levels.
• Trade Policies: Tariffs, subsidies, and trade agreements can alter competitive positions and influence the real exchange rate.

Therefore, understanding the broader economic policies is essential to grasp the intricacies of real exchange rate fluctuations.