Real Exchange Rate
The real exchange rate is the nominal exchange rate adjusted for differences in price levels between two countries. It measures the relative price of domestic goods and services in terms of foreign goods and services, and it is a key determinant of a country's international competitiveness.[1]
Definition
The real exchange rate can be expressed as:
- Real exchange rate = Nominal exchange rate × (Domestic price level ÷ Foreign price level)
An alternative formulation expresses the real exchange rate as the ratio of a country's price level expressed in a common currency to the foreign price level. A rise in the real exchange rate indicates that domestic goods have become relatively more expensive (a real appreciation); a fall indicates a real depreciation.[1]
Economic significance
The real exchange rate is important because it determines the relative competitiveness of a country's exports and the cost of its imports:
| Movement | Effect |
|---|---|
| Real appreciation | Exports become relatively more expensive; imports cheaper; trade balance tends to worsen. |
| Real depreciation | Exports become relatively cheaper; imports more expensive; trade balance tends to improve. |
Relationship to purchasing power parity
The concept of the real exchange rate is closely linked to purchasing power parity (PPP). Under absolute PPP, the real exchange rate equals one, meaning that a basket of goods costs the same in both countries when expressed in a common currency. In practice, real exchange rates deviate from one because of trade barriers, non-traded goods, and differences in productivity.[1]