What is the Real Exchange Rate?
The Real Exchange Rate (RER) is a measure used in economics that accounts for relative price levels between two countries. Unlike the nominal exchange rate which simply indicates how much one currency can be exchanged for another, the real exchange rate factors in inflation rates to assess the true exchange rate adjusted for a more accurate reflection of purchasing power.
Formula for Real Exchange Rate
The formula to calculate the Real Exchange Rate is:
\[ RER = e \cdot \left(\frac{P^*}{P}\right) \]
Where:
- \( RER \) = Real Exchange Rate
- \( e \) = Nominal Exchange Rate (foreign currency/domestic currency)
- \( P^* \) = Price level in the foreign country
- \( P \) = Price level in the domestic country
Examples
Nominal Exchange Rate Example: Assume the nominal exchange rate between the U.S. dollar and the Euro is 1.2 (1 USD = 1.2 EUR), and the inflation in the U.S. is 3% while in the Eurozone it is 1%.
Real Exchange Rate = 1.2 * (1.01/1.03) = 1.176
This adjusted rate shows the purchasing power parity after considering inflation rates between the countries.
Purchasing Power: If the nominal exchange rate between the Japanese Yen (JPY) and Indian Rupee (INR) is 1.5 (1 JPY = 1.5 INR), but Japan’s inflation rate is 2% and India’s is 5%, the real exchange rate would adjust the nominal rate to show true comparative value.
Real Exchange Rate = 1.5 * (1.02/1.05) = 1.457
Frequently Asked Questions (FAQs)
Q: Why is the Real Exchange Rate significant in international trade? A: The Real Exchange Rate provides a more accurate measure of a currency’s value and its purchasing power relative to other currencies, thereby offering better insight for decisions regarding imports and exports.
Q: How does inflation impact the Real Exchange Rate? A: Inflation affects the Real Exchange Rate by altering the relative price levels of two countries, which influences the real value of their currencies when exchanged.
Q: Can the Real Exchange Rate help in determining economic competitiveness? A: Yes, by adjusting for price level differences, the Real Exchange Rate can indicate how expensively or cheaply goods can be purchased relative to other countries, helping gauge economic competitiveness.
Related Terms
Nominal Exchange Rate: The rate at which one currency can be exchanged for another without adjusting for inflation effects.
Purchasing Power Parity (PPP): The theory that in the long term, exchange rates should move towards the rate that equalizes the prices of an identical basket of goods and services in any two countries.
Inflation: A measure of the rate at which the general level of prices for goods and services is rising, which erodes purchasing power.
Online References
- Investopedia - Real Exchange Rate
- Federal Reserve on Exchange Rates
- International Monetary Fund (IMF) - Exchange Rates and Inflation
Suggested Books for Further Studies
- “International Economics” by Paul R. Krugman and Maurice Obstfeld
- “Exchange Rate Economics: Theories and Evidence” by Ronald MacDonald
- “Macroeconomics: Theory and Policy” by Rudiger Dornbusch, Stanley Fischer, and Richard Startz
Accounting Basics: Real Exchange Rate Fundamentals Quiz
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