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.

Fig. 1 - Currency exchange office

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:

$Realexchangerate=TurkishLiraperUSD\times \frac{PriceintheUS}{PriceinTurkey}$

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:

$Realexchangerate=nominalexchangerate\times \frac{domesticprices}{foreignprices}$

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.

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.

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.

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:

$Realexchangerate=nominalexchangerate\times \frac{domesticprices}{foreignprices}$

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.

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.

Sources:

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