What is Real Exchange Rate?

The real exchange rate measures the relative price of goods and services between two countries, taking into account both the nominal exchange rate and the relative prices of goods in each country. It differs from the nominal exchange rate, which only reflects the price of one currency in terms of another.

Understanding Real Exchange Rate

The real exchange rate represents the purchasing power of a currency in one country relative to another. It reflects the amount of goods and services that can be purchased in one country with the same amount of money from another country.

Components

• Nominal Exchange Rate: The nominal exchange rate is the price of one currency in terms of another. For example, it could be the number of Japanese Yen needed to buy one US Dollar. It directly influences the real exchange rate.
• Relative Prices: Relative prices refer to the price of a specific good or service in one country compared to the same good or service in another country. These differences can impact the real exchange rate, as they affect the purchasing power of a currency. For example, if a cup of coffee costs $3 in the US and 300 Yen in Japan, the relative price of coffee is 100 Yen per dollar. This impacts the real exchange rate between the US and Japan.

Calculation

The real exchange rate is calculated by adjusting the nominal exchange rate for the difference in price levels between two countries. The formula for calculating the real exchange rate is:

Real Exchange Rate = Nominal Exchange Rate * (Domestic Price Level / Foreign Price Level)

Interpretation

• Higher Real Exchange Rate: A higher real exchange rate means that a country's goods and services are relatively more expensive compared to another country. This can make a country's exports less competitive, leading to lower demand for its goods and services in the international market.
• Lower Real Exchange Rate: A lower real exchange rate indicates that a country's goods and services are relatively cheaper compared to another country. This can boost export competitiveness, leading to higher demand for its goods and services in the global market.

Applications of Real Exchange Rate

Trade and Competitiveness

The real exchange rate plays a significant role in determining a country's trade competitiveness. A country with a lower real exchange rate enjoys an advantage in international markets as its goods and services are more affordable for foreign buyers. Conversely, a higher real exchange rate can make exports less competitive, potentially leading to a trade deficit.

Purchasing Power Parity (PPP)

Purchasing power parity (PPP) suggests that identical goods and services should have the same price in different countries after adjusting for the exchange rate. The real exchange rate can deviate from PPP due to various factors, such as transportation costs, trade barriers, and non-tradable goods. Deviations from PPP can provide insights into the relative price levels and the potential for arbitrage opportunities.

Investment Decisions

Companies often consider real exchange rates when making investment decisions. A favorable real exchange rate can make a country more attractive for foreign investment, as it suggests lower costs and higher returns. For example, a company might decide to invest in a country with a lower real exchange rate to take advantage of lower production costs and potentially higher export demand.

Real Exchange Rate and the Economy

Impact on Inflation

Fluctuations in the real exchange rate can impact inflation by affecting import prices. A depreciation of the real exchange rate makes imports more expensive, potentially contributing to higher inflation. Conversely, an appreciation of the real exchange rate can lead to lower import prices, potentially helping to keep inflation in check.

Impact on Growth

The real exchange rate can influence economic growth by affecting the competitiveness of exports and imports. A depreciation of the real exchange rate can boost export growth by making domestic goods and services cheaper for foreign buyers. However, it can also lead to higher import prices, potentially reducing consumer spending and overall economic activity.

Conclusion

The real exchange rate is a crucial economic indicator influencing international trade, purchasing power parity, investment decisions, and macroeconomic stability. Understanding its fluctuations is vital for informed decision-making in various economic contexts.