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What’s it: The real exchange rate is the price of one currency against another currency adjusted for differences in the price levels of domestic and foreign prices. The aggregate price level measure is inflation, which shows you the currency’s purchasing power for goods and services. In other words, the real exchange rate represents the nominal exchange rate after adjusting for the difference in inflation between the two countries.
Why the real exchange rate matters
Apart from economic growth indicators, interest rates, and inflation, the exchange rate is another indicator that is most widely seen. We observe the exchange rate to assess the soundness of a country’s economy. In particular, apart from affecting investment flows, exchange rates impact international trade flows.
Exports and imports depend not only on nominal exchange rates but also on domestic and foreign goods and services relative prices. Even when the nominal exchange rate is unchanged, differences in inflation rates can affect international trade because they impact domestic and foreign economies’ relative purchasing power.
Real exchange rate stability is important to promote economic growth and increase welfare. Its movements can affect exports and imports, ultimately affecting domestic production activities and gross domestic product.
Nominal vs. real exchange rate
Imagine you’re a European tourist planning a trip to the United States. As you exchange your Euros (EUR) for US Dollars (USD), the exchange rate plays a crucial role in determining your purchasing power. This is where the concept of nominal and real exchange rates comes in.
The nominal exchange rate is essentially a price tag, telling you how many US dollars you get for each Euro you exchange. It’s a static figure that reflects the current market value of one currency relative to another. So, if the exchange rate is EUR 1 = USD 1.20, it means you get $1.20 for every EUR1 you exchange.
A weakening euro and its impact
The Euro’s value can fluctuate. If the Euro weakens (depreciates) against the US dollar, you’ll need to exchange more Euros to get the same amount of US dollars. For example, a shift from EUR 1 = USD 1.20 to EUR 1 = USD 1.10 signifies a depreciation. This translates to needing more Euros to buy the same things in the US. Conversely, from an American perspective, a weaker Euro means their dollar strengthens (appreciates), allowing them to exchange fewer dollars for more Euros.
The nominal exchange rate only tells part of the story. Imagine you find a souvenir in the US priced at $10. While the exchange rate might tell you how many Euros you need for that $10, it doesn’t account for inflation – the general increase in prices.
- Weakening euro + rising us prices: If the Euro weakens and US prices rise simultaneously, your purchasing power gets squeezed. You’ll need more Euros (due to the exchange rate) to buy the same item, which has also become more expensive in US dollars.
- Inflation matters on both sides: Even if US prices remain stable, inflation in the Eurozone can impact your purchasing power. If your income stays the same in Euros while prices in Europe rise (Eurozone inflation), you have less purchasing power for US goods, even with a steady exchange rate.
The real exchange rate
This is where the real exchange rate comes in. It takes the nominal exchange rate and adjusts it for the relative inflation rates between two countries. By factoring in inflation, the real exchange rate gives you a more accurate picture of your purchasing power in another country.
In essence, the real exchange rate reflects how much “stuff” you can buy with your currency in another country, considering both exchange rates and inflation. Understanding this concept is crucial for travelers, businesses involved in international trade, and anyone interested in global economic trends.
How to calculate the real exchange rate
Before calculating, you will need data on nominal exchange rates and domestic and foreign price indices. The price index represents the aggregate price level, and changes over time represent the inflation rate. The widely used price index is the consumer price index (CPI).
Assume you are using the consumer price index. For calculations, you can use the real exchange rate formula below.
- Real exchange rate = Nominal exchange rate x (Foreign CPI/Domestic CPI)
Or, if we convert the CPI to a percentage of the inflation rate, the formula for the real exchange rate above will be:
- Real exchange rate = Nominal exchange rate x [(1 + Foreign inflation rate)/(1+ Domestic inflation rate)]
Let’s take a simple example and assume you are Indonesian. In 2010, the rupiah exchange rate was around IDR15,000/USD, and the consumer price index in Indonesia and the United States was at 100. In 2019, the exchange rate changed to IDR14,000/USD. Simultaneously, Indonesia’s inflation rose 5% due to the consumer price index rising to 105. Meanwhile, the United States’ inflation rate rose 10% due to the consumer price index rising to 110.
Apply the two formulas above to calculate the real exchange rate. The results should be as follows:
- The first formula = 14,000 x (110/105) = IDR14,666.67
- The second formula = 14,000 x (1+10%)/(1+5%) = IDR14,666.67
Why do the real exchange rates tend to be higher than the nominal exchange rates?
This is because the prices of US products rise higher than the price increases for domestic products. Thus, at nominal exchange rates, the domestic economy can buy only a few American products. This weakening purchasing power is reflected in the real exchange rate, which is higher than the nominal exchange rate. In other words, we can no longer get American products for the equivalent of domestic goods.
From this case, we can draw the following conclusions:
- Suppose the foreign inflation rate is higher than the domestic inflation rate. In that case, the real exchange rate will be higher than the nominal exchange rate.
- If the foreign inflation rate is equal to the domestic inflation rate, the real exchange rate will be equal to the nominal exchange rate.
- Suppose the foreign inflation rate is lower than the domestic inflation rate. In that case, the real exchange rate will be lower than the nominal exchange rate.
Remember, in drawing the conclusion above, I assume you are Indonesian.
Real Effective Exchange Rate (REER)
The concept of real exchange rates (RER) provides a more nuanced understanding of currency values compared to nominal exchange rates. But what if a country trades with a multitude of partners, not just one? This is where the Real Effective Exchange Rate (REER) steps in.
Imagine a country X that trades with countries Y and Z. The RER for X considers the exchange rates and inflation between X and both Y and Z, not just an isolated average. Here’s how it works:
- Nominal Effective Exchange Rate (NEER): This is a weighted average of X’s nominal exchange rates with its trading partners (Y and Z). The weights are based on the relative importance of each partner in X’s trade. For instance, if country Y contributes more to X’s trade than Z, it would have a higher weight in the NEER calculation.
- Real Effective Exchange Rate (REER): This takes the NEER a step further. It considers the inflation rates in X, Y, and Z. By adjusting the NEER for inflation, the REER provides a more comprehensive picture of X’s currency’s value relative to a basket of currencies of its trading partners.
Why REER Matters
The REER reveals a country’s competitiveness in international trade. A lower REER suggests that a country’s exports are becoming cheaper compared to its imports, potentially boosting its export competitiveness. Conversely, a higher REER indicates that exports are becoming relatively more expensive, which could dampen exports.
Understanding REER empowers investors, businesses, and policymakers to make informed decisions. Investors can gauge potential currency movements and their impact on international investments. Businesses can assess their export competitiveness in the global market. Policymakers can design strategies to influence a country’s trade balance.
By incorporating inflation and a broader range of trading partners, the REER offers a valuable tool for analyzing exchange rates and their impact on international trade.
Factors affecting the real exchange rate
Various factors influence the real exchange rate, including nominal exchange rates, domestic inflation, and foreign inflation. As in the formula above, the real exchange rate is a function of these three variables.
Term of trade. It is the ratio between the exported goods’ price and the country’s imported goods’ price. Changes in the prices of imported goods and exported goods reflect changes in inflation between domestic and overseas.
Expansionary policy. Both fiscal and monetary policies influence aggregate demand and the domestic inflation rate. For example, an increase in government spending increases the demand and prices for goods and services, thereby impacting the price level.
Trade restrictions. Import tariffs, for example, generally cause the real exchange rate to appreciate. Foreign goods become more expensive when they enter the domestic market. Thus, domestic consumers shift their purchases to local products, increasing their demand and prices.
Net capital inflows. Suppose the incoming investment is higher than the outgoing investment on a net basis. In that case, it increases the demand for the domestic currency. Thus, the nominal exchange rate will appreciate, as well as the real exchange rate (in the above formula, both have a positive correlation).
Devaluation. It makes domestic currency cheaper compared to other currencies. The government deliberately depreciates the nominal exchange rate, usually to encourage exports.
