Real exchange rates (RER) refer to the rate of exchange between two currencies that is the product of the nominal exchange rate (the dollar cost of a euro, for example) and the ratio of prices between the two countries.
When we talk about “real” in finance terms, it typically translates as something that is inflation-adjusted.
For example, in terms of interest rates, a “real interest rate” is one that takes the nominal interest rate minus the rate of inflation.
This is important to know in order to determine the inflation-adjusted return of an investment yield or borrowing rate.
The real exchange rate is essentially the price of one currency in terms of another currency after taking into account price differentials in one item or a group of items in both countries.
Real exchange rates can therefore shed insight into cost of living differences between two countries.
There are a number of factors that can affect real exchange rates. These include a country’s inflation rate, as well as interest rates and government policies.
Net exports and the real exchange rate
A key economic relationship exists between net exports and the real exchange rate within a country.
When the real exchange rate is high, the relative prices of goods and services at home are higher than the relative prices of goods and services abroad.
In this case, importing is likely because foreign goods are less expensive than domestic goods in real terms.
Therefore, when the real exchange rate is high, net exports are expected to decrease as imports rise.
Or, when the real exchange rate is low, net exports increase as exports rise.
This relationship shows the real-world effects of changes in the real exchange rate.
It’s also why, from a policy standpoint, some emerging countries would like a weaker currency – it helps their manufacturing sector by helping them export more.
What is the difference between a nominal exchange rate and real exchange rate?
While the nominal exchange rate tells how much foreign currency can be exchanged for a unit of domestic currency, the real exchange rate tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country.
Real exchange rate formula
In terms of how to calculate the real exchange rate, it is usually calculated using the following formula:
Real Exchange Rate = Nominal Exchange Rate x Price Ratio of Foreign Country / Price Ratio of Home Country
Real exchange rate example
Let’s say that we wanted to determine the real exchange rate for a gallon of gas between the US and UK.
And let’s say that the nominal exchange rate between these countries is 1.30 GBP per dollar (GBP/USD), or $1 = £0.77.
Let’s say that the price of gas in the UK is £1.67 per liter (there are 3.78 liters per gallon, so that’s £6.31) and the price of gas in the US is $4 per gallon. We are looking to compare equivalent types of gas in this example.
Here we begin with the equation for the real exchange rate of real exchange rate = (nominal exchange rate X domestic price) / (foreign price).
Plugging in the numbers from above gives real exchange rate = (1.30 X $4) / £6.31 = 0.82 gallons of UK gas per gallon of American gas.
This would tell you that the price of UK gas is higher than the price of US gas after adjusting for the exchange rate.
By using both the nominal exchange rate and the real exchange rate, we can find important information about the relative cost of living between two countries.
A high nominal exchange rate give the impression that a unit of domestic currency will be able to purchase many foreign goods. However, only a high real exchange rate would make this assumption correct.
What factors influence real exchange rates?
There are a number of factors that can affect real exchange rates. These include:
If a country’s inflation rate is higher than that of another country, its currency will tend to depreciate against the other currency.
However, sometimes it won’t, but we can still capture the difference in relative costs via the real exchange rate.
Higher interest rates tend to lead to appreciation of a currency, as investors will seek to invest in a country with higher returns.
Government policies can also influence real exchange rates. For example, if a government imposes trade restrictions (such as tariffs), this will tend to lead to a depreciation of its currency.
What are the implications of real exchange rates?
Real exchange rates can have a number of implications for a country.
These can include:
A country’s real exchange rate can affect its trade balance. If a country’s currency appreciates, its exports will become more expensive and its imports will become cheaper.
This can lead to a decrease in the country’s exports and an increase in its imports, leading to a trade deficit.
A country’s real exchange rate can also affect the flow of capital into and out of the country.
For example, if a country’s currency appreciates, this will make it relatively more expensive for foreign investors to buy assets in the country.
This could lead to a decrease in foreign investment and an outflow of capital from the country.
As mentioned above, real exchange rates can also influence inflation. If a country’s currency appreciates, the prices of its imports will increase, leading to higher inflation.
Real exchange rates can also affect a country’s interest rates. If a country’s currency appreciates, its interest rates will tend to rise, as investors will seek to invest in the country.
Higher inflation can also cause higher interest rates.
Real exchange rates can also affect a country’s economic growth.
If a country’s currency appreciates, its exports will become more expensive and its imports will become cheaper.
This can lead to a decrease in demand for the country’s exports and an increase in demand for its imports. This can lead to slower economic growth.
What determines the real exchange rate and the nominal exchange rate in the short run?
In the short run, basic supply and demand impact exchange rates. Any number of transactions can occur for various reasons to influence an exchange rate.
These can include:
If a country exports more than it imports, this leads to positive hard currency flows and creates a demand for its currency.
If there is a large inflow of capital into a country, this will create a demand for the country’s currency.
Higher interest rates tend to attract foreign investment and lead to a demand for the country’s currency.
Governments can intervene in the foreign exchange market to buy or sell their own currency in order to influence its value.
A country can buy its own currency through its FX reserves.
What determines real exchange rates in the long run?
In the long run, real exchange rates are determined by a country’s productivity.
Productivity is a measure of how efficient a country is in producing goods and services.
A country with a high level of productivity will be able to produce more goods and services than a country with a lower level of productivity.
This will lead to a higher demand for the country’s currency and an appreciation of the currency.
For instance, when people talk about the renminbi relative to the dollar, they talk about how China has 4x the population of the US and if they become even half as productive as Americans, their economy will be twice as large.
Accordingly, it might make sense for the RMB to appreciate against the USD over the long run.
What are some real exchange rate risks?
There are a number of real exchange rate risks. These include:
– Interest rate risk: If interest rates fall due to lower real growth, this could lead to a depreciation of the currency.
– Inflation risk: If inflation increases, this could lead to a depreciation of the currency.
– Economic growth risk: If economic growth slows, this could lead to a depreciation of the currency.
– Political risk: If there is political instability, this could lead to a depreciation of the currency.
– Exchange rate risk: If a currency is pegged to another and the fundamentals don’t support it, this could lead to a devaluation or unpegging.
What are some benefits of having a high real exchange rate?
There are a number of benefits to having a high real exchange rate. These include:
– Trade: A country may be able to import more and lead to a higher standard of living in the country. This can help to boost economic growth.
– Investment: The real exchange rate can influence investment in a country. A higher real exchange rate can help bring in more foreign capital and reduce the acuity between the inflation and growth trade-off that central banks face. They can get more growth per unit of inflation. This can help to boost economic growth.
– Interest rates: The high real exchange rate can influence interest rates by making it cheaper for foreigners to lend money to the country. This can help to boost economic growth.
– Exchange rates: The high real exchange rate can make it easier for the country to maintain a stable exchange rate.
– Prices: A high real exchange rate can influence prices by making it harder for domestic companies to increase prices because lots of foreign goods may be cheaper. This can help to keep inflation in check.
What causes exchange rates to become more volatile?
There are a number of factors that can cause exchange rates to become more volatile. These include:
– Interest rate changes: If interest rates have a less certain forward path, this could lead to more exchange rate volatility.
– Inflation: If inflation volatility increases, this could lead to more currency volatility.
– Economic growth: If the volatility in economic growth increases, this could lead to more currency volatility.
– Political instability: If there is political instability, this could lead to more volatility in the currency.
– Changes in other countries: If there is instability in other countries (growth, inflation, geopolitics, acts of nature (e.g., pandemic, flood, drought)), this could lead to bigger expected moves in the real exchange rate.
What’s the difference between purchasing power parity (PPP) and real exchange rate (RER)?
Purchasing power parity (PPP) is a state where a single basket of domestic goods and services always trades for a single basket of foreign goods and services.
Accordingly, PPP implies a constant real exchange rate.
To the extent that PPP does not hold in the short run, then the real exchange rate will vary over time.
Big Mac Index and PPP
What is the Big Mac Index?
The Big Mac Index is a tool used to measure the purchasing power parity (PPP) between two currencies.
It does this by comparing the price of a Big Mac in one currency to the price of a Big Mac in another currency.
The Big Mac Index was created by The Economist in 1986 as a (non-serious) way to measure whether a currency was overvalued or undervalued.
How is the Big Mac Index calculated?
To calculate the Big Mac Index, The Economist takes the price of a Big Mac in one currency and divides it by the price of a Big Mac in another currency.
For example, if the price of a Big Mac in US dollars is $4 and the price of a Big Mac in euros is €3, the Big Mac Index would be 4/3, or 1.33.
This means that the purchasing power of the US dollar is 1.33 times greater than the euro.
What does the Big Mac Index tell us?
The Big Mac Index can be used to measure the purchasing power parity (PPP) between two currencies.
PPP is the idea that two currencies should have equal purchasing power if they are both undervalued or overvalued by the same amount.
For example, if the US dollar is undervalued by 10 percent and the euro is undervalued by 5 percent, then the purchasing power of the US dollar is 1.10 times greater than the euro.
What are the limitations of the Big Mac Index?
The Big Mac Index is not a perfect measure of PPP, but it is a useful tool for comparing the purchasing power of two currencies.
One limitation of the index is that it does not take into account other factors that can affect the price of a Big Mac, such as taxes or subsidies.
Another limitation is that the index only measures the PPP between two currencies, and does not take into account other economic factors, such as inflation or interest rates.
Despite these limitations, the Big Mac Index is a helpful tool for comparing the relative purchasing power of two currencies.
Summary – Real Exchange Rates
Real exchange rates are the rates at which two currencies are traded after adjusting for the relative price levels in the underlying economies.
They can be used to measure the value of a currency when adjusting for inflation rates and compare cost of living between two countries.
Real exchange rates can be affected by a number of factors, including interest rates, inflation, economic growth, and political instability. Exchange rates can become more volatile when these factors change.