Real Exchange Rates: What Money Can Buy

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The nominal exchange rate is the price of one currency in terms of another (example: it costs a U.S. dollar holder $1.36 to buy one euro; from a euroholder’s perspective the nominal rate is 0.735 euros per dollar).
The real exchange rate (RER) measures the value of a country’s goods against those of another country, a group of countries, or the rest of the world, at the prevailing nominal exchange rate.
Core equation: RER = eP*/P, where e is the nominal exchange rate, P* is the average price of a good in the foreign area, and P is the average price of the good in the domestic country.
Big Mac illustration:
- If e = 1.36, German price = 2.5 euros, U.S. price = $3.40, then RER = (1.36) X (2.5) ÷ 3.40 = 1.
- If German price = 3 euros and U.S. price = $3.40, then RER = 1.36 X 3 ÷ 3.40 = 1.2.
Interpretation: An RER of 1 implies purchasing power parity for the representative good; an RER of 1.2 implies the euro is 20 percent overvalued relative to the dollar for that good.
Arbitrage logic: if the same good is cheaper in one country, buying it there and selling it in the other raises demand for the cheaper currency and pressures the nominal exchange rate to adjust, absent frictions (transportation, trade barriers, consumption preferences).

For multiple products, RER is typically measured using a broad basket of goods and expressed as an index (e.g., consumer price index–based RER index).
Index interpretation example: if an index is 100 in 2000 and 120 in 2011, average prices are 20 percent higher than in 2000.
Real effective exchange rate (REER) definition: an average of bilateral RERs between the country and each trading partner, weighted by trade shares of each partner.
An REER can show no overall misalignment even if the currency is overvalued relative to some partners and undervalued relative to others.
REERs can deviate due to changes in consumption baskets, trade policies, tariffs, and transportation costs; deviations do not necessarily imply fundamental misalignment.
Historical volatility: among advanced economies a century ago REER fluctuations were within a 30 percent band; in the 1980s the United States experienced swings in its REER as wide as 80 percent.

Not all large REER fluctuations signal misalignment; smooth large adjustments can reflect fundamentals rather than disequilibrium.
Productivity changes in tradables: technology-driven productivity increases in tradable goods lower production costs and can cause REERs to rise to maintain equilibrium.
Distinction between tradables and nontradables:
- Tradables face international price competition and tend to equalize across countries absent barriers.
- Nontradables (houses, many personal services) face minimal international price competition and can have widely differing prices; fluctuations in nontradable prices account for much of REER variation across countries.
Other factors affecting REERs: persistent changes in terms of trade (example: oil producers), differences in fiscal policies, tariffs, and financial development.
Estimation challenges: prices are somewhat sticky in the short run while nominal exchange rates can be volatile (where market determined), making equilibrium RER estimation difficult.
Short-run volatility: REERs typically display considerable short-run volatility in response to news and noisy trading.

REERs have signaled large exchange rate overvaluations in the run-up to many financial crises; monitoring bilateral RERs and multilateral REERs is important for policy surveillance.
Failures in assessing misalignment can lead to massive realignments with severe consequences (example: the 1992 ERM crisis following speculative attacks, including George Soros’s $1 billion bet against the British pound).
Policy relevance: overvalued currencies face pressure to depreciate, undervalued currencies face pressure to appreciate, but government policies can hinder normal equilibration and complicate trade disputes.
The IMF and other analysts take real exchange rate fundamentals into account when estimating the “equilibrium” REER around which the actual REER should hover if there is no misalignment.

Source: Real Exchange Rates: What Money Can Buy — Luis Catão, F&D Magazine