What is the Real Exchange Rate?

The real exchange rate (RER) is a crucial concept in international economics that measures the purchasing power of one country's currency relative to another. It is not just about the nominal value of one currency in terms of another but also takes into account the relative prices of goods and services between the two countries. In this article, we will delve into the definition, calculation, and significance of the real exchange rate using the latest data and figures.

Definition of Real Exchange Rate

The real exchange rate (RER) is defined as the product of the nominal exchange rate (NER) and the ratio of prices between the two countries. The core equation for calculating RER is:

RER = e × P*/P

Where:

• e is the nominal exchange rate (the price of one currency in terms of another),
• P* is the average price of a good in the foreign country,
• P is the average price of the same good in the home country.

For example, if the nominal exchange rate is 1.36 USD per euro, and the average price of a Big Mac in Germany is 2.5 euros while in the United States it is $3.40, then the RER would be calculated as:

RER = 1.36 × 2.5/3.40 ≈ 1

This means that if the German price were 3 euros, the RER would be 1.2, indicating that the Big Mac costs less in Germany relative to the United States.

Calculation of Real Exchange Rates

To illustrate further, let's consider another example. Suppose the nominal exchange rate between the US dollar and the euro is 1.36 USD per euro. If the average price of a Big Mac in Germany is 3 euros and in the United States it is $3.40, then:

RER = 1.36 × 3/3.40 ≈ 1.2

This calculation shows that the Big Mac costs approximately 20% less in Germany than in the United States when adjusted for the exchange rate and prices.

Significance of Real Exchange Rates

Real exchange rates are significant because they help economists and policymakers understand the relative purchasing power of different currencies. An appreciation in the real exchange rate indicates that a country's currency is overvalued relative to its trading partners, making its goods and services more expensive in foreign markets. Conversely, a depreciation in the real exchange rate suggests that a country's currency is undervalued, making its goods and services cheaper abroad.

For instance, the massive U.S. trade deficit with China has been attributed to a misaligned real exchange rate. If the real exchange rate between the U.S. dollar and the Chinese yuan is significantly lower than equilibrium levels, it means that Chinese goods are cheaper for U.S. consumers, potentially contributing to the trade imbalance.

Effective Exchange Rates

While bilateral real exchange rates provide insights into the relative prices of goods between two countries, effective exchange rates (EERs) offer a broader perspective by averaging bilateral real exchange rates across multiple trading partners. The BIS effective exchange rate indices cover 64 economies and serve as a measure of international competitiveness and financial conditions.

Effective exchange rates are calculated as geometric weighted averages of bilateral exchange rates, with weights derived from manufacturing trade flows. This method captures both direct bilateral trade and third-market competition by double-weighting. The BIS also uses time-varying weights to accommodate changes in trade patterns over time.

Practical Applications

Understanding real exchange rates is crucial for various financial decisions, including investment strategies and trade policies. For instance, if a country's real exchange rate is appreciating, it may indicate that its currency is becoming overvalued, potentially leading to reduced exports and increased imports. Conversely, a depreciating real exchange rate could signal undervaluation, making exports more competitive in foreign markets.

In conclusion, the real exchange rate is a powerful tool for assessing the relative purchasing power of different currencies. By considering both nominal exchange rates and relative prices, it provides a comprehensive view of international trade dynamics. As global economies continue to evolve, understanding the real exchange rate remains essential for informed decision-making in finance and trade.