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

What Are Real Exchange Rates?

Real exchange rates measure the relative price of goods and services between two countries, accounting for their nominal exchange rates and their respective price levels. Unlike a nominal exchange rate, which simply reflects the price of one currency in terms of another, the real exchange rate provides insight into the actual purchasing power of a currency in a global context. This concept is fundamental to international finance and is a key indicator of a country's economic competitiveness. An understanding of real exchange rates helps economists and policymakers analyze trade flows, capital movements, and overall economic performance.

History and Origin

The concept of real exchange rates is rooted in economic theories concerning international trade and the determination of exchange rates. Early economic thought, particularly the theory of purchasing power parity (PPP), laid the groundwork by suggesting that exchange rates should adjust to equalize the prices of a common basket of goods across countries. While PPP itself often faces empirical challenges in the short run due to factors like transportation costs and non-traded goods, it provided the conceptual basis for adjusting nominal exchange rates for price differentials.

Economists began to rigorously develop the framework for real exchange rates to better understand deviations from PPP and their implications for trade and economic policy. Notable contributions to the study of real exchange rates include the extensive work by economists like Rudiger Dornbusch, whose research in the late 20th century explored the behavior and macroeconomic significance of these rates in both developed and developing economies. His 1988 paper, "Real Exchange Rates and Macroeconomics: A Selective Survey," delved into the determination and implications of real exchange rates within various macroeconomic models, highlighting their importance beyond simple monetary considerations.⁹ This academic rigorousness helped cement the real exchange rate as a critical analytical tool in macroeconomic analysis.

Key Takeaways

Real exchange rates adjust nominal exchange rates for differences in price levels between countries, reflecting the true purchasing power of a currency.
They are crucial for assessing a country's international competitiveness, as an appreciation in the real exchange rate can make exports more expensive and imports cheaper.
Changes in real exchange rates can influence a nation's trade balance and capital flows.
Policymakers and analysts use real exchange rates to understand currency valuation (undervalued, overvalued, or equilibrium) and to formulate monetary policy and trade strategies.

Formula and Calculation

The real exchange rate (RER) between two countries can be calculated using a straightforward formula that incorporates the nominal exchange rate and the price levels in both countries.

The formula is:

RER = E \times \frac{P^*}{P}

Where:

(RER) = Real Exchange Rate
(E) = Nominal Exchange Rate (expressed as units of domestic currency per unit of foreign currency, e.g., USD/EUR)
(P^*) = Foreign price level (e.g., Consumer Price Index in the Eurozone)
(P) = Domestic price level (e.g., Consumer Price Index in the United States)

Alternatively, if the nominal exchange rate (E) is expressed as units of foreign currency per unit of domestic currency (e.g., EUR/USD), the formula would be:

RER = \frac{E \times P}{P^*}

The price levels ((P^*) and (P)) are typically represented by a broad price index, such as the Consumer Price Index (CPI) or the Producer Price Index (PPI). When analyzing the real exchange rate against a basket of currencies, a weighted average is often used, leading to the concept of the real effective exchange rate (REER). The International Monetary Fund (IMF) and the Bank for International Settlements (BIS) commonly publish such indices.⁸,⁷

Interpreting the Real Exchange Rate

Interpreting the real exchange rate involves understanding what a higher or lower value signifies about a country's international economic position. An increase in the real exchange rate indicates a real currency appreciation. This means that domestic goods and services are becoming relatively more expensive compared to foreign goods and services. Conversely, a decrease in the real exchange rate signals a real currency depreciation, meaning domestic goods are becoming relatively cheaper.

For example, if the real exchange rate of the U.S. dollar against the euro increases, it implies that American products are more expensive for European consumers, and European products are cheaper for American consumers. This shift can impact a country's trade flows, potentially leading to a decrease in exports and an increase in imports. Policymakers closely monitor real exchange rates as they provide insights into a nation's economic health and its competitive standing in global markets.

Hypothetical Example

Consider a hypothetical scenario involving the United States and Japan.

Let's assume:

Nominal exchange rate (E) = 150 Japanese Yen (JPY) per 1 U.S. Dollar (USD)
Price of a specific good (e.g., a standard laptop) in the U.S. (P) = $1,200
Price of the same standard laptop in Japan (P*) = ¥180,000

First, we need to convert the Japanese price into U.S. dollars using the nominal exchange rate:
¥180,000 / 150 JPY/USD = $1,200

Now, we can calculate the real exchange rate. If we express the nominal exchange rate as units of domestic currency (USD) per foreign currency (JPY), which would be 1/150 = 0.00667 USD/JPY, and the prices are relative (U.S. price / Japanese price in USD):

RER = E_{USD/JPY} \times \frac{P_{JPY}}{P_{USD}}

However, a more intuitive approach for comparing purchasing power directly is to see how many U.S. goods one unit of Japanese goods can buy, or vice versa, adjusted for prices.

Using the original definition of (E) as domestic per foreign, say USD/JPY for the U.S. perspective:
(E) = 0.00667 USD/JPY (i.e., $0.00667 buys 1 JPY)
(P^*) = 180,000 JPY (Japanese laptop price)
(P) = 1,200 USD (U.S. laptop price)

RER = 0.00667 \times \frac{180,000}{1,200} = 0.00667 \times 150 = 1.0005

A real exchange rate of approximately 1.0 indicates that, after accounting for the nominal exchange rate, the laptop costs roughly the same in both countries. If the U.S. laptop price were to remain at $1,200 but the Japanese laptop price increased to ¥200,000, and the nominal exchange rate stayed at 150 JPY/USD, then:

RER = 0.00667 \times \frac{200,000}{1,200} = 0.00667 \times 166.67 \approx 1.11

This new real exchange rate of approximately 1.11 implies that U.S. goods (represented by the laptop) are now relatively cheaper than Japanese goods, making U.S. exports to Japan more attractive. This change in the real exchange rate highlights a shift in relative purchasing power.

Practical Applications

Real exchange rates are vital tools for a variety of economic analyses and decision-making processes. Central banks and governments monitor real exchange rates to assess a nation's trade competitiveness and guide monetary policy decisions. A sustained real appreciation can indicate a loss of export competitiveness, potentially harming industries that rely on international trade. Conversely, a real depreciation can boost exports and curb imports, supporting domestic industries.

Investors also use real exchange rates to evaluate potential returns on international investments. When considering investments in foreign assets, the real exchange rate influences the real return on those assets after accounting for both nominal currency movements and domestic and foreign inflation. For example, a country with a depreciating real exchange rate might see its exports become more attractive, potentially leading to stronger economic growth and better investment opportunities in export-oriented sectors.

International organizations like the International Monetary Fund (IMF) and the Federal Reserve regularly compile and publish real exchange rate indices, such as the Real Broad Dollar Index published by the St. Louis Federal Reserve, to track a currency's value against a basket of trading partners, adjusted for inflation., T⁶h⁵ese indices provide a comprehensive view of a currency's real effective value, which is crucial for assessing macroeconomic conditions and formulating policy. The IMF, for instance, provides detailed explanations of its methodologies for calculating real effective exchange rates and how they reflect international economic relationships.

#⁴# Limitations and Criticisms

While real exchange rates offer a more comprehensive view than their nominal counterparts, they are not without limitations. One primary challenge lies in accurately measuring the "price level" ((P) and (P^*)) in different countries. Different indices, such as the Consumer Price Index (CPI) or the Producer Price Index (PPI), can yield varying real exchange rate calculations, and the composition of these baskets of goods and services may not be perfectly comparable across economies.

F³urthermore, the concept of a "misalignment" of the real exchange rate (i.e., whether it deviates from its long-run equilibrium) can be difficult to determine. Economic models that attempt to estimate equilibrium real exchange rates often rely on a range of underlying economic fundamentals like productivity, terms of trade, and government spending, but these models can be complex and subject to different assumptions. Sh²ort-term fluctuations in nominal exchange rates can also lead to significant volatility in real exchange rates, which may not always reflect fundamental changes in economic competitiveness but rather speculative movements in the foreign exchange market. Some research suggests that a large portion of real exchange rate fluctuations may be due to deviations from the law of one price for traded goods, rather than solely changes in the relative price of nontraded goods.

A¹dditionally, real exchange rates are backward-looking in their calculation, using historical price data. This can limit their predictive power, especially in rapidly changing economic environments where inflation differentials or nominal exchange rates are highly volatile.

Real Exchange Rates vs. Nominal Exchange Rates

The key distinction between real exchange rates and nominal exchange rates lies in the inclusion of price levels. A nominal exchange rate simply states how much of one currency can be exchanged for another. For example, if 1 U.S. dollar trades for 0.95 euros, that is a nominal exchange rate. This rate tells a trader how many euros they get for their dollars in the foreign exchange market.

In contrast, the real exchange rate adjusts this nominal rate for the relative price levels of goods and services in each country. It provides a measure of how much a basket of goods and services in one country costs compared to the same basket in another country, when expressed in a common currency. This adjustment is crucial because the purchasing power of a currency is eroded by inflation. Therefore, while nominal exchange rates are relevant for immediate transactions and currency conversion, real exchange rates offer a more accurate representation of a country's trade competitiveness and the relative cost of living or doing business across borders. The nominal rate might show a currency appreciation, but if domestic inflation is significantly higher than foreign inflation, the real exchange rate might still depreciate or appreciate by a lesser extent, impacting the true cost of goods.

FAQs

Why are real exchange rates important for trade?

Real exchange rates are important for trade because they determine the relative prices of goods and services between countries. A real depreciation makes a country's exports cheaper for foreign buyers and its imports more expensive for domestic consumers, which can boost net exports and improve the trade balance.

How do real exchange rates affect investment?

Real exchange rates influence the profitability of international investments. A real appreciation of the domestic currency can reduce the local currency value of returns from foreign investments when repatriated. Conversely, a real depreciation might enhance those returns. Investors consider real exchange rates to gauge the true return on their international portfolios, accounting for both currency movements and relative inflation.

What is the difference between bilateral and effective real exchange rates?

A bilateral real exchange rate compares the purchasing power between two specific currencies, adjusted for their respective price levels. An effective real exchange rate, often called the real effective exchange rate (REER), is a weighted average of a currency's bilateral real exchange rates against a basket of other major trading partners' currencies. The weights are typically based on the volume of trade with each partner. This provides a broader measure of a currency's overall international competitiveness.

Do central banks target real exchange rates?

Central banks generally do not explicitly target real exchange rates. Their primary mandates usually revolve around price stability (controlling inflation) and maximizing employment. However, they closely monitor real exchange rates as a key indicator of external economic conditions, which can influence inflation, economic growth, and the overall effectiveness of monetary policy. Significant misalignments in real exchange rates can prompt policy responses if they threaten macroeconomic stability.