Real exchange rate

Definition

The real exchange rate is the price of one country's goods and services relative to another country's goods and services, adjusted for price level differences between the two countries. It reflects how much of one country's currency is needed to purchase the same basket of goods that can be purchased with a different country's currency, taking inflation and cost of living into account. This concept is crucial for understanding international trade dynamics and purchasing power across different economies.

5 Must Know Facts For Your Next Test

1. The real exchange rate can indicate whether a country is competitive in international markets; a higher real exchange rate may suggest that a country's goods are more expensive compared to others.
2. Real exchange rates can fluctuate due to changes in nominal exchange rates or differences in inflation rates between countries.
3. When analyzing trade balances, a country's real exchange rate plays a key role, as it affects export and import levels.
4. Real exchange rates are often used in economic models to predict capital flows and investment decisions by firms looking to operate internationally.
5. A country experiencing high inflation relative to its trading partners will see its real exchange rate appreciate, making its exports more expensive and imports cheaper.

Review Questions

• How does the real exchange rate impact a country's trade balance?
  • The real exchange rate directly affects a country's trade balance by influencing export and import prices. If the real exchange rate rises, it typically means that domestic goods are more expensive compared to foreign goods, which can lead to a decline in exports and an increase in imports. Conversely, if the real exchange rate falls, domestic goods become cheaper for foreign buyers, potentially boosting exports and improving the trade balance.
• Evaluate the relationship between nominal exchange rates and real exchange rates, especially in light of inflation differences.
  • Nominal exchange rates represent the raw value at which currencies can be exchanged without accounting for inflation. In contrast, real exchange rates adjust this nominal value by considering relative price levels or inflation rates between countries. For instance, if a country has a nominal exchange rate that appreciates but simultaneously experiences higher inflation than its trading partner, its real exchange rate could actually depreciate, affecting its competitiveness in global markets.
• Discuss the significance of purchasing power parity (PPP) in relation to understanding real exchange rates across different economies.
  • Purchasing power parity (PPP) provides a theoretical framework that helps explain how real exchange rates should adjust over time. If PPP holds true, then over the long term, changes in nominal exchange rates should correspond to changes in price levels between countries, leading to equal purchasing power for identical goods. Thus, real exchange rates serve as an important indicator of whether currencies are undervalued or overvalued compared to their expected PPP levels, which can inform investment strategies and economic policies.

Related terms

nominal exchange rate:

The nominal exchange rate is the rate at which one currency can be exchanged for another without adjusting for inflation or price level changes.

purchasing power parity (PPP): Purchasing power parity is an economic theory that suggests that in the long run, exchange rates should adjust so that identical goods in different countries have the same price when expressed in a common currency.

inflation rate: The inflation rate is the percentage increase in the general price level of goods and services in an economy over a specified period.