Real exchange rate

From Hobson's Choice

The ratio of a currency's real purchasing power to its nominal exchange rate.

1 Context
2 Computation of Real Exchange Rate
3 RER and Purchasing Power Parities
4 External Links

Context

The nominal exchange rate of two currencies is determined by instantaneous conditions of supply and demand for the two currencies. In addition to the actual purchasing power that any two currencies may command in their respective home markets, there may be a prolonged current account deficit, or there may be unexpected changes in capital flows. A regulatory regime unpopular with investors may lead to a chronic shortage of foreign currency. Finally, there may exist a disparity in inflationary expectations between two currency zones.

One of the better ways of explaining the distinction between real and nominal exchange rates is to imagine two countries, A and B, with corresponding currencies a and b. A has an inflation rate during the year of 11%, while B has no inflation at all. At the beginning of the year, a:b was 10 (i.e., one a could buy 10 b). Suppose that, at the end of the year, this ratio is unchanged.

If the ratio is unchanged, then clearly the purchasing power of A has risen 11% in B's markets. This is a windfall for As consumers, who will want to buy more goods from B; Bs consumers, naturally, will find that their purchasing power has fallen 10%. Producers selling into each other's markets will have opposite attitudes: a producer in B will find that she can raise prices (in b) by as much as 11% and have the same sales volume to A as before.

Intuitively, we should expect that the exchange rate would not be unchanged; more realistically, the rate would change from 10 b = 1 a to 9 b = 1 a.

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Computation of Real Exchange Rate

The most common definition of the real rate is the nominal exchange rate adjusted by price levels.

where e is the price of one unit of a foreign currency in units of domestic currency, p* is the foreign price level, and p is the domestic price level.

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RER and Purchasing Power Parities

A purchasing power parity exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. It is often used to compare the standards of living between countries. In some cases, such as the OECD data linked below, GDP/GDP per capita data are available as calculated in local currencies, and one divides the GDP by the PPP to get the GDP in "OECD currency units." An OECD currency unit is an imaginary unit which is derived from the OECD average, but is very close in purchasing power to one US dollar (it's worth about $0.972). Hence, the GDP of Germany is €2,244,600 million. This needs to be divided by the German PPP deflater of 0.868, to get a figure of 2,585,944 million. We can do the same thing for the USA (PPP deflater 0.972) to get 12,732,613 million. These two figures provide a more accurate comparison of purchasing power than that provided by using the foreign exchange ratio of $1.58:€1.00.

The ratio of .869 (Germany) to 0.972 (USA) reflects the fact that the euro buys about 11.9% more in Germany than the US dollar buys in the USA. At the same time, the nominal exchange rate is 1.58 (as of 11 April 2008), suggesting that the US dollar has a RER of 1.4125 with respect to the euro (in Germany). In Finland, the deflater is 0.956, and the RER is 1.55, suggesting that Finland has perhaps the most overvalued currency on earth.

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