Real exchange rate
The real exchange rate of one currency with respect to another is the purchasing power of a currency after its conversion.
In other words, the real exchange rate is a measure that indicates the purchasing power of one currency against another. Unlike the nominal exchange rate, it takes into account the prices in the country to which the currency belongs.To understand this, it is necessary to know several concepts well. These concepts are defined in the following links:
- Currency pair.
- Nominal exchange rate.
- Purchasing power.
In financial markets, currencies are traded in the form of currency pairs. When we change one currency, we always change it in terms of another. For example, we have euros and we want to change to Argentine pesos. Or, we have US dollars and we want Indonesian rupiahs.
The ratio of one currency to another is known as the nominal exchange rate. Continuing with the previous example, the nominal exchange rate answers the question, for each euro, how many Argentine pesos do they give me? Or for every US dollar how many rupees will I get.
Finally and before getting into the concept of the real exchange rate, we must know what purchasing power means. Purchasing power tells us something like the amount of things we can buy with a currency in one country or another. For example, $ 10 is $ 10 anywhere in the world. Now, do you buy the same amount of goods with $ 10 in New York and with $ 10 in Memphis? The amount of money is the same, but New York is a very expensive city and Memphis, in comparison, very cheap.
Calculation of the real exchange rate
The formula used to calculate the real exchange rate is:
RER = Real exchange rate
TCN = nominal exchange rate
Pe = Prices in the foreign country
Pn = National prices
The real exchange rate: digging deeper into the concept
With the introduction to the key concepts we are in a position to understand well the concept of the real exchange rate. The real exchange rate, when taking into account the prices of two places with different currencies, adjusts the nominal exchange rate to the prices. Although later we will see a numerical example, a priori, several conclusions can be reached.
- Nominal exchange rate is equal to the real one.
If the nominal exchange rate equals the real exchange rate, then the relative prices are the same. That is to say, although in one place the prices are in dollars and in another in pesos, it is equivalently the same.
For example, for every dollar they give us 30 Argentine pesos. So, for the nominal exchange rate to be equal to the real exchange rate, we should, on average, be able to buy the same with one dollar in the United States as with 30 pesos in Argentina. Continuing with the example, suppose that the reference price is coffee. So if in the United States, on average, coffee is worth one dollar, then in Argentina, on average, coffee is worth 30 pesos.
- Real exchange rate is higher than nominal.
If the real exchange rate is higher than the nominal, it means that the prices of the reference currency are higher. In simpler words, my currency buys more things abroad than in my country. Let's continue with the previous example and remember that for every dollar they give us 30 Argentine pesos. This means that with one dollar you can buy more things in Argentina than with 30 pesos in the United States. Following the example of coffee. In the United States the price of coffee is worth 1 dollar, while in Argentina it is worth 15 pesos. So actually for every coffee we buy in the United States, we can buy two in Argentina.
- Nominal exchange rate higher than the real one.
If the nominal exchange rate is higher than the real one, it means that the prices of the reference currency are lower. In a simpler way, with the same money I buy less abroad than in my country. For every dollar they give us 30 Argentine pesos. If the nominal exchange rate is higher than the real exchange rate, I buy less things with 1 dollar in Argentina than with 30 pesos in the United States.
In the previous examples, we have always taken the dollar as a reference. If we do the opposite, the conclusion will be the opposite.
Real exchange rate example
To see it more clearly we will make a numerical example:
Suppose the existence of two countries A and B. Both in country and country B only cars are produced. Of course, in each country the price of a car is in its currency. In country A a car is priced at $ 300. For its part, in country B the price of the car is 6000 pesos
- Nominal exchange rate (TCN): 30 pesos per dollar
- Prices abroad (Pe): $ 300 a car
- National prices (Pn): 6000 pesos a car
In real terms with a dollar, we can buy 1.5 times more than with the equivalent in pesos. In other words, a car in country A is equivalent to 1.5 cars from country B. More simply, we can exchange 2 cars from country A for three cars from country B. In the calculation what we do is pass everything to the same unit (weights). So a car in A is worth 9000 pesos and a car in B is worth 6000 pesos.
Another example. Suppose now that everything stays the same. Now, in country B a car is worth 9000 pesos.
In real terms, the dollar and the peso are worth the same. With 30 pesos I can buy in country A, the same as with a dollar in country B. I can exchange a car from country A for a car from country B.Real interest rate