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. Thus, it ultimately affects domestic production activities and gross domestic product.
The difference between the real exchange rate and the nominal exchange rate
Assume that you are an Indonesian and want to convert rupiah to US dollars. The nominal exchange rate tells you how many US dollars you get when you exchange rupiah in your pocket.
Let’s take an example to explain it.
The rupiah’s nominal exchange rate against the US dollar increased from IDR14,000/USD to IDR14,200/USD. In this case, Indonesians would say their rupiah depreciates. Because to get 1 US dollar, they have to convert more rupiahs, from IDR14,000 to IDR14,200. On the other hand, Americans see the US dollar appreciating because, with 1 US dollar, they can convert it to rupiah and earn more, from IDR14,000 to IDR14,200.
Say the price of a product in the United States does not change and is still priced at one US dollar. Depreciation weakens your ability to buy the product. You will no longer be able to buy it at IDR14,000 if converted into rupiah. To get it, you have to pay IDR14,200 (1 US dollar).
Now, assume the price of the product rises by about 5% and becomes USD1.05. That, of course, will further weaken your purchasing power of these products, ceteris paribus.
Say, to buy an American product, you rely on the income from selling your product in the local market. Assume that the product price and sales volume do not increase, and therefore the money you earn does not change. As a result, your purchasing power for American products is weaker because your income does not increase apart from its rising price.
Now we loosen up the assumptions. Say your sales volume is unchanged, but the price of your product increases by 5%. Therefore, your money also increases by 5%. Your purchasing power over American products does not change. Even though the price has increased by 5%, you will have 5% more money due to your product price increase.
Now, if the price increase (your product and American product) applies to all goods and services in the economy, we call it inflation. Therefore, to measure the domestic economy’s purchasing power over American products, you consider the nominal exchange rate and the relative difference between the domestic inflation rate and the United States’ inflation rate. In economics, if we adjust the nominal exchange rate to the relative difference between the two inflation rates, that is the real exchange rate.
How to calculate the real exchange rate
Before calculating, you will need data on nominal exchange rates, domestic and foreign price indices. We use the price index to represent the aggregate price level, where 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 equals the domestic inflation rate, the real exchange rate will equal 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 and nominal effective exchange rate
The formula above is a simple example. And in reality, international trade involves a variety of goods and services. Transactions also consist of not only one or two countries, but almost most of them.
Economists then developed an exchange rate index to cover various products and various countries to answer this problem.
- Nominal effective exchange rate – the weighted average bilateral nominal exchange rate between a country and its trading partners. Weights correspond to trading contributions with each partner.
- Real effective exchange rate – the same as the nominal effective exchange rate. However, we use a weighted average of real exchange rates.
Factors affecting the real exchange rate
Various factors influence the real exchange rate. Nominal exchange rates, domestic inflation, and foreign inflation are among them. 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.