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Real Exchange Rate

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Real Exchange Rate

Imagine you are planning to take a trip to Istanbul, Turkey, and you find out that the hotel you were going to book increased its price from 2000 Turkish Lira to 3000 Turkish Lira, a 50% increase in price. Should you still go? You'll find the answer to that after you read our explanation on the real exchange rate.

Real Exchange Rate definition

Think about two countries that trade with one another, for example - the U.S. and Turkey. For the first half of 2021 one dollar was equal to about 8.5 Turkish Lira (TRY). At the end of 2021, the Turkish Lira started to depreciate against the dollar, reaching a record of around 16 TRY per dollar. Currently, one dollar equals about 14 TRY.1

What does this mean for U.S citizens? Does it mean that Turkish products became cheaper for U.S. citizens? You would assume that one dollar would now buy you more Turkish products, but that is not the case. What happened is that besides the Turkish Lira losing value against the dollar, prices in Turkey increased as well. So even though one dollar gets you more Turkish Lira, it doesn’t mean that you can buy more things when you travel to Turkey. To capture the effect of price level changes on the purchasing power between countries, economists use real exchange rate.

The real exchange rate is the exchange rate between countries that takes into account the price level between these countries.

Real Exchange Rate, Currency Exchange Office, StudySmarterCurrency exchange office, Wikimedia Commons,https://commons.wikimedia.org/wiki/File:Bureau_de_change.JPG

Real exchange rate formula

Think about two countries that trade with one another, for example - the U.S. and Turkey. The real exchange rate between these two countries can be calculated by using the following formula:

To better understand what the real exchange rate means, assume that the Turkish Lira has depreciated 50% against the dollar in one year: from one dollar buying you 8 TRY, it went to one dollar buying you 12 TRY. At the same time, the prices in Turkey have gone up 50% for every good and service offered, whereas the prices remained the same in the U.S.

The real exchange rate before the price change and depreciation is equal to:

We are taking the value of the base year equal to 100 to capture the price level difference between the two years.

After the prices have increased in Turkey together with the depreciation, the real exchange rate became equal to:

where 150 is the 50% increase in the price level in Turkey.

Notice that the real exchange rate has remained the same after the Turkish Lira has depreciated by 50% and Turkey experienced a 50% inflation.

This means that in this year, just like in the previous year, the real exchange rate is actually the same.

What does the same real exchange rate mean for U.S. citizens? This means for U.S. citizens that although it looks like they can buy more with one dollar, in fact, they can buy the same amount as before due to the increase in prices in Turkey.

The main aim of the real exchange rate is to capture and show how much change there is in purchasing power between countries when price levels are also taken into account.

The more general formula for the real exchange rate that is easier to remember is:

If you can't remember whether the nominal exchange rate is in terms of domestic currency per foreign currency or the other way around, just remember that all the currencies symbols in the calculation need to cancel out!

The nominal exchange rate is the rate at which the domestic currency is exchanged for the foreign currency. And domestic prices represent the prices at the home country, which we are taking into account, whereas foreign prices are the prices of the goods and services abroad.

Real exchange rate example

Assume you are in the United States and one dollar is equal to 22 Mexican pesos. You want to find out how many tacos you get in Mexico for a taco you get in the United States when the average price of Tacos is $1.69 in the U.S. and it is 15 pesos in Mexico.

To find out the answer to this, you use the formula of the real exchange rate:

Plugging in the values into the equation:

The answer means that a taco in the U.S. is equal to 2.47 tacos in Mexico.

Difference between nominal and real exchange rate

The nominal exchange rate is the rate at which a currency may be exchanged for another currency at face value. A dollar will buy 14 Turkish lira at the nominal exchange rate between the dollar and the lira if the nominal exchange rate is 14. Unless otherwise stated, exchange rates are always expressed as the amount of foreign currency that may be bought for one unit of local currency. The nominal exchange rate is calculated by determining the amount of foreign money that may be acquired for one unit of local currency. It is usually determined by supply and demand in the foreign exchange market.

The nominal exchange rate is the rate at which a currency may be exchanged for another currency at face value.

On the other hand, the real exchange rate is a little more complex. Instead of stating how much foreign money can be traded for a unit of local currency, the real exchange rate states how much products and services in the home nation can be swapped for goods and services in another country.

Consider the following scenario: we wish to establish the real exchange rate for cheese between the United States and Turkey. We are aware that the nominal exchange rate between these two nations is 14 TRY per USD at the time of writing. We also know that the cost of cheese is 60 TRY per pound in Turkey, whereas the cost of cheese in the United States is 5 USD per pound.

In this situation, we start with the equation for the real exchange rate, which is:

What does this mean?

It means that in real terms you can exchange 1 pound of U.S. cheese for 1.2 pounds of Turkish cheese.

To get valuable insight into two nations' relative cost of living differences, you must use both the nominal exchange rate and the real exchange rate in your calculations. While a high nominal exchange rate may provide the mistaken impression that a unit of local currency would be able to buy a large number of foreign items, in fact, only a high real exchange rate can justify such an assumption in the first place.

Determinants of real exchange rate

There are three main determinants of the real exchange rate:

  • nominal interest rate
  • foreign prices
  • domestic prices

Any change in one of these variables will also cause a change in the real exchange rate.

Consider the formula of the real exchange rate:

The real exchange rate is a function of these three variables. That means that whenever there is a change in one of these three variables, it will also cause the real exchange rate to change.

The key to understanding whether the real exchange rate increases or decreases is to always refer to the formula of the real exchange rate.

Nominal exchange rate

An increase in the nominal exchange rate, whilst keeping domestic prices and foreign prices fixed, will cause the real exchange rate to appreciate. This means you can buy more foreign goods with U.S. goods. As you're counting the nominal exchange rate in terms of foreign currency per dollar, when the nominal exchange rate increases, it means that one dollar can get you more of foreign currency. This means that the value of the real exchange rate will appreciate as well, everything else equal.

Domestic prices

Whenever there is an increase in domestic prices, there will also be an appreciation in the real exchange rate as it is positively correlated with domestic prices. An appreciation in the real exchange rate means that one U.S. good gives you more of foreign goods. This makes sense as your local products are getting more expensive, each one of them should be able to provide you with more foreign goods, everything else being equal.

Foreign prices

An increase in foreign prices will cause the real exchange rate to depreciate, meaning that you would need more domestic goods in exchange for the same amount of foreign goods. Think of it this way: if the real exchange rate was equal to two, meaning two foreign goods for one domestic good, and then the real exchange rate decreased to one due to an increase in price levels in the foreign country. This means that you can get only one foreign good for one of your U.S. goods. So to get 2 foreign goods as before, you would now need more of U.S. goods.

Factors influencing the real exchange rate

Factors that influence the real exchange rate include: terms of trade, monetary policy, capital inflows and trade restrictions.

Terms of trade

Terms of trade are the relationship between the price of exported products and the price of imported items into the domestic economy. Whenever you have export prices (domestic prices) that increase more than the import prices (foreign prices), you will have positive terms of trade, and as a result, the real exchange rate will appreciate. On the other hand, when you have negative terms of trade, meaning that the import prices increase in relation to the export prices, the real interest rate will depreciate.

Monetary policy

Monetary policy can influence the nominal interest rates directly, which would affect the real interest rate. If the Fed was to pursue an expansionary monetary policy, it would cause an increase in aggregate demand through lower interest rates. This would increase the price level in the economy. This will then cause the real exchange rate to appreciate as fewer domestic goods get you more foreign goods.

Capital inflows

Assume that there are more capital inflows than capital outflows, meaning more investment is coming in the country than exiting. This would cause an increase in demand for the local currency, which causes the nominal exchange rate to appreciate. As the real exchange rate is positively correlated with the nominal exchange rate, the real exchange rate will also appreciate.

Trade restrictions

Whenever the government decides to impose tariffs on imports, the real exchange rate tends to appreciate. Think about it: when tariffs are imposed, foreign goods become more expensive for domestic consumers. This affects the real exchange rate directly (remember the formula). But there is also an indirect effect. This will push domestic consumers to consume more of their domestic products causing an increase in domestic product demand, which would cause an increase in demand for domestic currency and nominal exchange rate appreciation, and, as a result, the real exchange rate would appreciate as well.

Real Exchange Rate - Key takeaways

  • The real exchange rate is the exchange rate between countries that takes into account the price level between these countries.
  • The real exchange rate formula is:
  • Instead of stating how much foreign money can be traded for a unit of local currency (nominal exchange rate), the real exchange rate states how many products and services in the home nation can be swapped for goods and services in another country.
  • One of the main uses of the real exchange rate is to get valuable insight into two nations' relative cost of living differences.
  • There are three main determinants of the real interest rate: nominal interest rate, foreign prices, and domestic price level.
  • Factors that influence the real exchange rate are: Terms of trade, Monetary policy, Capital inflows, Trade restrictions.

Sources:

1. Trading Economics - US Dollar Turkish Lira exchange rate chart, 2021

Frequently Asked Questions about Real Exchange Rate

One of the main uses of the real exchange rate is to get valuable insight into two nations' relative cost of living differences. 

There are three main determinants of the real exchange rate: nominal interest rate, foreign prices, and domestic prices. Any change in one of these variables will also cause a change in the real exchange rate.

The real exchange rate is the exchange rate between countries that takes into account the price level difference between these countries.

Real exchange rate = nominal exchange rate x (domestic prices/foreign prices)

Instead of stating how much foreign money can be traded for a unit of local currency, the real exchange rate states how many products and services in the home nation can be swapped for goods and services in another country.

Final Real Exchange Rate Quiz

Question

What is real exchange rate used for?

Show answer

Answer

One of the main uses of the real exchange rate is to get valuable insight into two nations' relative cost of living differences. 

Show question

Question

What changes the real exchange rate?

Show answer

Answer

There are three main determinants of the real exchange rate: nominal interest rate, foreign prices, and domestic price level. Any change in one of these variables will also cause a change in the real exchange rate.

Show question

Question

What is real exchange rate?


Show answer

Answer

The real exchange rate is the exchange rate that takes into account the price level difference between the countries.

Show question

Question

What is the difference between nominal and real exchange rates?


Show answer

Answer

Instead of stating how much foreign money can be traded for a unit of local currency, the real exchange rate states how much products and services in the home nation can be swapped for goods and services in another country.

Show question

Question

What is the nominal exchange rate?

Show answer

Answer

The nominal exchange rate is the rate at which a currency may be exchanged for another currency at face value. 

Show question

Question

How is the nominal exchange rate calculated?

Show answer

Answer

The nominal exchange rate is calculated by determining the amount of foreign money that may be acquired for one unit of local currency. It is usually determined by supply and demand in the foreign exchange market.

Show question

Question

How does the nominal exchange rate impact the real exchange rate?

Show answer

Answer

An appreciation of the nominal exchange rate will cause the real exchange rate to appreciate, everything else being equal. A depreciation of the nominal exchange rate will cause the real exchange rate to depreciate, everything else being equal. 

Show question

Question

Why an increase in the nominal exchange rate can lead to an appreciation of the real exchange rate?

Show answer

Answer

As you're counting the nominal exchange rate in terms of foreign currency per dollar, when the nominal exchange rate increases or appreciates, it means that one dollar can get you more of foreign currency. This implies that the real exchange rate value will be higher, everything else being equal.

Show question

Question

How domestic prices affect the real exchange rate?

Show answer

Answer

Whenever there is an increase in domestic prices, there will also be an increase in the real exchange rate as it is positively correlated with domestic prices. The increase in the real interest rate means that your one U.S. good gives you more foreign goods. This makes sense as your local products are getting more expensive, each one of them should be able to provide you with more foreign goods.

Show question

Question

How does the foreign price level affect the real exchange rate?

Show answer

Answer

An increase in foreign prices will cause the real exchange rate to depreciate, meaning that you would need more domestic goods in exchange for the same amount of foreign goods. Think of it this way: if the real exchange rate was equal to two, meaning two foreign goods for one domestic good, and then the real exchange rate decreased to one due to an increase in price levels of the foreign country. This means that you can get only one foreign good for one of your U.S. goods. So to get 2 foreign goods as before, you would now need more of U.S. goods.

Show question

Question

What are the factors that influence the real exchange rate?

Show answer

Answer

Factors that influence the real exchange rate are: Terms of trade, Monetary policy, Capital inflows, Trade restrictions.

Show question

Question

How terms of trade influence the real exchange rate?

Show answer

Answer

Terms of trade are the relationship between the price of exported products and the price of imported items into the nation. Whenever you have export prices that increase more than the import prices, you will have positive terms of trade, and as a result, the real exchange rate will appreciate. 

Show question

Question

How can monetary policy influence the real exchange rate?

Show answer

Answer

Monetary policy can influence the nominal interest rates directly, which would affect the real interest rate. If the Fed was to pursue an expansionary monetary policy, it would cause an increase in aggregate demand through lower interest rates. This would increase the price level in the economy. This will then cause the real exchange rate to appreciate as fewer domestic goods get you more foreign goods.

Show question

Question

How do capital inflows influence the real exchange rate?

Show answer

Answer

Assume that there are more capital inflows than capital outflows, meaning more investment is coming in the country than exiting. This would cause an increase in demand for the local currency, which causes the nominal exchange rate to appreciate. As the real exchange rate is positively correlated with the nominal exchange rate, the real exchange rate will also appreciate.

Show question

Question

How do trade restrictions influence the real exchange rate?

Show answer

Answer

Whenever the government decides to impose tariffs on imports, the real exchange rate tends to appreciate. Think about it: when tariffs are imposed, foreign goods become more expensive for domestic consumers; therefore, it will push domestic consumers to consume more of their own domestic products. This will lead to an increase in domestic products and, as a result, in a real exchange rate appreciation.

Show question

Question

What is the real exchange rate when Jamie can purchase $500 for 356£ at the airport and if a bag that they buy in the UK for 60£ costs them $76 in the US?

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Answer

1.11

Show question

Question

 You can purchase $1.68 for 1 franc. If you buy a bar of chocolate in Frankland, you will spend 2.87 francs. If you buy the same bar of chocolate in the US you will spend $4.00. For every bar of chocolate purchased in Frankland, how many can you purchase in the US?

Show answer

Answer

1.21 bars of chocolate.

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Question

The exchange rate is 20 pesos for $1. If Barry buys 10 bolts of fabric from Mexico at 87 pesos per bolt, he pays $35 altogether. In the US Barry would have to pay $10 per bolt. What is the real exchange rate? Round to two digits.

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Answer

2.30 

Show question

Question

What is the relationship between the price of exported products and the price of imported items into the domestic economy called? 

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Answer

Terms of trade.

Show question

Question

A(n) ____________ in the nominal exchange rate, while domestic prices and foreign prices ___________, will cause the real exchange rate to appreciate.


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Answer

increase, are fixed

Show question

Question

How many goods one currency can buy in terms of another depends on the currency's...

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Answer

purchasing power.

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Question

Whenever there is an increase in _____________, there will also be a(n) _____________ in the real exchange rate as it is positively correlated with domestic prices.

Show answer

Answer

domestic prices, appreciation

Show question

Question

Why might a tariff on imports cause the exchange rate to appreciate?

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Answer

Because it would increase domestic consumption. 

Show question

Question

To really understand a country's cost of living we only need the nominal exchange rate.

Show answer

Answer

False, we need to understand both the nominal and the real exchange rates to evaluate the differences in prices of the same goods.

Show question

Question

When the nominal exchange rate decreases you can buy_______ foreign goods with your currency.

Show answer

Answer

More.

Show question

Question

How would higher capital outflows than inflows affect demand for domestic currency?

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Answer

The nominal exchange rate would depreciate.

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Question

What will happen with the real exchange rate if it is positively correlated with the nominal exchange rate?


Show answer

Answer

The real exchange rate will appreciate.

Show question

Question

What is an example of a capital inflow?

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Answer

Investment into a country.

Show question

Question

What might happen to the real exchange rate if the Fed decides to implement an expansionary monetary policy?

Show answer

Answer

It would lower interest rates, which would increase domestic prices, making foreign goods appear cheaper.

Show question

Question

When foreign goods begin to appear cheaper, what can you assume is happening to your domestic currency?

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Answer

You can assume it is appreciating.

Show question

Question

When import prices do not increase as much as domestic prices, what does that say about your terms of trade and your exchange rate?

Show answer

Answer

It means you have positive terms of trade and an appreciating exchange rate.

Show question

Question

When you have negative terms of trade, why does the exchange rate depreciate?

Show answer

Answer

It depreciates because the import prices increase in relation to the export prices.

Show question

Question

If the nominal exchange rate and the real exchange rate both appreciate, what does that say about the purchasing power of the domestic currency?

Show answer

Answer

It tells us that the domestic currency is becoming more valuable in that it can purchase a larger number of foreign goods.

Show question

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