Real Exchange Rates: Everything You Need to Know
International economics deals with complex questions, from trading between different countries to the value of one currency compared to another. To those new to economic concepts, the term real exchange rates may seem quite confusing. What exactly does it refer to, and what role does it play?
The concept provides us with information on the relative strengths of different currencies, so it’s undoubtedly a useful measure used by specialists. Even though it doesn’t consider many factors, it offers a good idea of price differences around the world.
If you want an easy-to-understand real exchange rate definition and how to calculate the real exchange rate, keep reading this article to find out.
What Does the Real Exchange Rates Mean?
To understand the real exchange rates meaning, it’s essential to start with the basic definition. While the term may seem bewildering, the actual idea is pretty simple.
The real effective exchange rate, also commonly known as REER, refers to the rate between selected countries, which considers the difference in their price levels. The calculation involves the weighted average of domestic currency as it relates to a basket of other currencies or an index.
The ultimate takeaway from this explanation is that when a country’s REER goes up, its imports become less expensive while exports are higher in price. When this happens, it means that there is an issue with the nation’s competitive edge in the global market. As such, this rate can be used as a measure showing how effectively a country can achieve its monetary goals in contrast with a specific trade partner.
Another thing to be familiar with is that any currency can be either in equilibrium, undervalued, or overvalued in relation to those of partners involved in trade. The desirable state is equilibrium, which refers to the balance of supply and demand. When it is achieved, prices stabilize. In this way, the goal of the REER measurement is to see whether such a balance is reached and how well it is held by a nation.
A REER breakdown cannot be complete without comparing it to the so-called nominal effective exchange rate, or NEER for short. Similar to REER, this indicator is used to determine a country’s competitive edge in trading. NEER is obtained by calculating the weighted average of exchange rates, and the main difference from REER is that it is not inflation-adjusted.
It needs to be said that NEER works well for assessing a country’s currency movements in the short term, while REER is more suited for long-term trade balance analysis.
Real Exchange Rate Formula: How It Is Calculated
To calculate real exchange rates of two currencies, you need first to take the NEER and then the price ratio between the chosen countries. To turn theoretical knowledge into practice, let’s take a look at the following economic formula:
Real Exchange Rate = Nominal Exchange Rate x Average Foreign Price/Average Domestic Price
As you can see, calculating the real exchange rate involves determining the nominal one by choosing currencies and then the ratio of the foreign and domestic prices of a certain product.
To illustrate the example, let’s take a chain present in numerous countries around the world—for example, Starbucks. We will use their popular Tall Latte as a product to calculate the real exchange rate formula for the United States (dollar) and Spain (euro).
To start, we need to get a nominal one. At the moment, it costs $1.09 to buy 1 euro and 0.91 euros to buy $1. For the formula, we will use the dollar cost of a euro—$1.09. As for the average prices, the Tall Latte costs $3.26 in the United States and around €3.70 in Spain.
Now let’s calculate using the formula provided above:
$1.09 (NEER) x 3.70 euros (Spain price) ÷ $3.26 (US price) = 1.2.
As a result of the calculation, we can conclude that the real exchange rate is 1.2. If we had received the rate of 1, we could say that the price of a Tall Latte in both countries would be the same if we converted them to a single currency. However, this is not the case in our example.
Given the RER of 1.2, a Tall Latte is 20% more expensive in Spain than in the United States.
This is a simple real-life example using a single product that is the same in both countries, as it is sold under a single franchise. The formula can be used to calculate non-identical products in different countries and thus get an understanding of the cost of living in them.
Conclusion
The real exchange rate is a valuable concept widely used in international economics. Its purpose is to clearly measure the value of different currencies around the world. The calculation is used to find whether a certain currency is overvalued or undervalued.
As the formula used shows, the real effective exchange rate has limitations. It doesn’t consider factors such as tariffs and price changes that can have a direct influence on the trading process. Still, it can be used as a straightforward tool to measure the value of goods in different countries.
Now that you have an idea of how to find the real exchange rate, you can use various products and apply the provided formula. As a result, you will have a better understanding of the price formation and the relative difference in the cost of living in selected regions.
