Real exchange rate: Meaning, Criticisms & Real-World Uses

What Is Real Exchange Rate?

The real exchange rate measures the value of one currency against another, adjusted for the price levels of the goods and services in each country. This concept is fundamental to International Finance, providing a more accurate representation of the relative purchasing power between two economies than a simple nominal currency conversion. Unlike the nominal exchange rate, which reflects only the market rate, the real exchange rate accounts for differences in inflation and price levels, offering insights into the competitiveness of a country's goods and services in international markets. It effectively indicates how many units of a foreign country's goods can be purchased with one unit of domestic goods.

History and Origin

The concept of the real exchange rate is rooted in the broader theory of purchasing power parity (PPP), which suggests that, in the absence of transportation costs and trade barriers, identical goods should have the same price in different countries when expressed in a common currency. While PPP often serves as a theoretical long-run benchmark, the real exchange rate accounts for deviations from this ideal by incorporating actual price levels. The systematic study and measurement of real exchange rates gained prominence with the shift to floating exchange rate regimes in the early 1970s, as economists and policymakers sought to understand underlying competitive dynamics beyond volatile nominal rates. Organizations like the Organisation for Economic Co-operation and Development (OECD) regularly publish data on purchasing power parities, which are crucial for calculating real exchange rates and comparing macroeconomic indicators across countries.⁴

Key Takeaways

The real exchange rate adjusts the nominal exchange rate for differences in domestic and foreign price levels, reflecting the relative cost of goods and services between countries.
It serves as a key indicator of a country's international competitiveness, influencing international trade flows and the balance of payments.
A real exchange rate appreciation indicates that domestic goods are becoming more expensive relative to foreign goods, while a depreciation means domestic goods are becoming cheaper.
Factors such as inflation differentials, productivity changes, and government policies significantly impact the real exchange rate.
Understanding the real exchange rate is crucial for analyzing capital flows, formulating monetary policy, and assessing economic stability.

Formula and Calculation

The real exchange rate can be calculated using the following formula:

R = N \times \left( \frac{P^*}{P} \right)

Where:

(R) = Real exchange rate
(N) = Nominal exchange rate (expressed as foreign currency per unit of domestic currency)
(P^*) = Foreign price level (e.g., Consumer Price Index in the foreign country)
(P) = Domestic price level (e.g., Consumer Price Index in the domestic country)

The price levels ((P) and (P^*)) are typically represented by broad price indexes, such as the Consumer Price Index (CPI) or the Producer Price Index (PPI), to capture the general cost of a basket of goods and services in each economy.

Interpreting the Real Exchange Rate

Interpreting the real exchange rate involves understanding its implications for a country's economic standing and competitiveness. If the real exchange rate increases (appreciates), it means that a country's goods and services are becoming more expensive relative to those of its trading partners. This can lead to a decline in exports and an increase in imports, potentially affecting the current account balance. Conversely, a decrease (depreciation) in the real exchange rate implies that domestic goods are becoming cheaper, which can boost exports and reduce imports, enhancing a country's trade competitiveness.

Policymakers and economists closely monitor real exchange rates as they provide insights into the underlying economic forces at play beyond mere currency fluctuations. The real exchange rate helps assess whether a country's economy is gaining or losing competitiveness on the global stage, affecting decisions related to trade policy and foreign direct investment. It also reflects how relative prices between countries are evolving.

Hypothetical Example

Consider the real exchange rate between the United States and the Eurozone.

Assume:

Nominal exchange rate ((N)) = 1.05 euros per U.S. dollar (meaning 1 USD buys 1.05 EUR)
U.S. Consumer Price Index ((P)) = 120 (base year = 100)
Eurozone Consumer Price Index ((P^*)) = 110 (base year = 100)

Using the formula:

R = 1.05 \times \left( \frac{110}{120} \right)

R = 1.05 \times 0.9167

R \approx 0.9625

In this example, the real exchange rate is approximately 0.9625. This means that a basket of goods and services that costs $1 in the U.S. would cost the equivalent of 0.9625 units of the Eurozone's basket of goods when adjusted for the nominal exchange rate and relative price levels. If this value were to increase over time (e.g., to 1.05), it would imply a real currency appreciation for the U.S. dollar, indicating that U.S. goods are becoming more expensive relative to Eurozone goods, irrespective of the nominal currency movements.

Practical Applications

The real exchange rate has several practical applications in economics and finance:

International Competitiveness Analysis: Businesses and policymakers use the real exchange rate to gauge a country's competitive position in the global market. A higher real exchange rate can make a country's exports more expensive and imports cheaper, impacting industries reliant on trade.
Monetary Policy Formulation: Central banks, such as the Federal Reserve, consider real exchange rate movements when formulating monetary policy. Significant appreciation can dampen inflationary pressures by making imports cheaper, while depreciation can fuel inflation. The Federal Reserve regularly publishes foreign exchange rate data, which informs their broader economic assessments.³
Economic Research and Forecasting: Economists use the real exchange rate to analyze long-term trends in trade balances, capital flows, and economic growth. Research from institutions like the National Bureau of Economic Research (NBER) often delves into the relationship between real exchange rates, interest rates, and other macroeconomic variables.²
Investment Decisions: Investors in the foreign exchange market and those involved in international equity or bond markets look at real exchange rates to assess potential returns adjusted for purchasing power. For example, a country with a depreciating real exchange rate might offer more attractive investment opportunities for foreign buyers due to lower relative costs.

Limitations and Criticisms

Despite its utility, the real exchange rate has limitations and faces criticisms. One major challenge lies in accurately measuring price levels across countries, especially for non-traded goods and services. Different methodologies for calculating price indices, such as the CPI, can lead to varying real exchange rate figures, making direct comparisons difficult.

Another critique relates to the "Balassa-Samuelson effect," which suggests that countries with higher productivity growth in their tradable goods sector tend to experience real exchange rate appreciation. This is because higher productivity in tradables leads to higher wages across the economy, pushing up prices of non-tradable goods and services without a corresponding increase in their productivity. Therefore, an observed real appreciation might not necessarily signify a loss of competitiveness but rather a natural outcome of economic development.

Furthermore, short-term fluctuations in the real exchange rate can be driven by factors other than underlying economic fundamentals, such as speculation in the foreign exchange market or sudden shifts in asset prices. These movements may not reflect changes in true purchasing power or trade competitiveness. The International Monetary Fund (IMF) acknowledges the complexities of managing exchange rates, especially for emerging economies, where their role as a monetary policy tool is more pronounced and vulnerable to shocks.¹

Real Exchange Rate vs. Nominal Exchange Rate

The distinction between the real exchange rate and the nominal exchange rate is crucial for understanding international economic relations. The nominal exchange rate is simply the rate at which one currency can be exchanged for another in the market, without any adjustment for price differences. For example, if 1 U.S. dollar can be exchanged for 150 Japanese Yen, 150 is the nominal exchange rate. This rate is easily observable and widely reported.

In contrast, the real exchange rate adjusts this nominal rate to reflect the relative purchasing power of the currencies. It tells us how many units of a foreign country's goods and services can be bought with one unit of domestic goods and services. While nominal exchange rates are affected by immediate market forces, speculative activity, and central bank interventions, the real exchange rate incorporates the effects of inflation differentials between countries. This means that even if the nominal exchange rate remains constant, a country with higher inflation will see its real exchange rate appreciate, making its goods more expensive relative to foreign goods. Confusion often arises because nominal rates are what most people encounter daily, but real rates provide a deeper insight into economic competitiveness and trade balances.

FAQs

What does a real exchange rate appreciation mean?

A real exchange rate appreciation means that a country's goods and services are becoming more expensive compared to foreign goods and services. This can make exports less competitive and imports more attractive.

How is inflation related to the real exchange rate?

Inflation directly impacts the real exchange rate. If a country's domestic inflation rate is higher than that of its trading partners, its real exchange rate will tend to appreciate, even if the nominal exchange rate remains stable, because its goods are becoming relatively more expensive.

Why is the real exchange rate a better measure of competitiveness than the nominal exchange rate?

The real exchange rate is a better measure of competitiveness because it accounts for differences in price levels between countries. The nominal exchange rate only reflects the market price of currencies, not the actual purchasing power of those currencies in terms of goods and services. The real exchange rate provides a more accurate picture of a country's ability to compete in international trade.

Can a government influence its real exchange rate?

Yes, a government can influence its real exchange rate indirectly through its macroeconomic policies, particularly monetary policy and fiscal policy. For example, a central bank raising interest rates can attract foreign capital, leading to a nominal currency appreciation, which, depending on inflation differentials, could result in a real appreciation. Fiscal policies affecting aggregate demand and price levels also play a role.