Real exchange rate
The real exchange rate (RER) is a very useful measure of the competitiveness of an economy. It tells us whether the prices of goods and services at home are higher or lower than their prices abroad. If domestic prices are lower, then we can expect healthy exports and a trade surplus. If domestic prices are higher, then we can expect sluggish exports and a trade deficit.
Formally, the real exchange rate is calculated as follows. Take the U.S. and Canada as an example.
RER of the U.S. dollar vs. Canadian dollar = ( U.S. prices / Canadian prices * Exchange rate of the U.S. dollar vs. the Canadian dollar) * 100
In the numerator is an index of prices in the U.S. In the denominator is an index of the Canadian prices, converted to U.S. dollars with the U.S. dollar/Canadian dollar exchange rate. If prices in the two countries are the same, then the RER is 100. If U.S. prices are higher than Canadian prices, the RER > 100. If U.S. prices are lower than Canadian prices, the RER < 100.
If the RER < 100, then we say that the domestic currency is undervalued. Domestic prices are low by international standards and domestic producers are competitive. If the RER > 100, then we say that the domestic currency is overvalued: domestic prices are too high and domestic producers are not competitive.
What do we mean by “prices”? We can compute the real exchange rate with the consumer price index (the CPI). Then we capture the goods and services consumed by urban households. We could compute it with the GDP deflator. Then we capture all goods and services. We could also compute it with a narrow price index for a particular industry. Then, we get a more precise measure of the competitiveness of a specific industry.
Formally, the real exchange rate is calculated as follows. Take the U.S. and Canada as an example.
RER of the U.S. dollar vs. Canadian dollar = ( U.S. prices / Canadian prices * Exchange rate of the U.S. dollar vs. the Canadian dollar) * 100
In the numerator is an index of prices in the U.S. In the denominator is an index of the Canadian prices, converted to U.S. dollars with the U.S. dollar/Canadian dollar exchange rate. If prices in the two countries are the same, then the RER is 100. If U.S. prices are higher than Canadian prices, the RER > 100. If U.S. prices are lower than Canadian prices, the RER < 100.
If the RER < 100, then we say that the domestic currency is undervalued. Domestic prices are low by international standards and domestic producers are competitive. If the RER > 100, then we say that the domestic currency is overvalued: domestic prices are too high and domestic producers are not competitive.
What do we mean by “prices”? We can compute the real exchange rate with the consumer price index (the CPI). Then we capture the goods and services consumed by urban households. We could compute it with the GDP deflator. Then we capture all goods and services. We could also compute it with a narrow price index for a particular industry. Then, we get a more precise measure of the competitiveness of a specific industry.
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