Real Exchange RateEdit
Real exchange rate
Real exchange rate (RER) is the price-adjusted measure of a country’s currency value relative to another country, capturing how competitive its goods and services are on world markets. It combines the nominal exchange rate with domestic and foreign price levels to reflect the cost of domestic goods in foreign terms. In its simplest bilateral form, RER is often written as RER = e × (P / P*), where e is the nominal exchange rate (foreign currency per unit of domestic currency), P is the domestic price level, and P* is the foreign price level. A rise in the real exchange rate (an appreciation in real terms) makes domestically produced tradables more expensive abroad and imports cheaper, all else equal; a fall (a real depreciation) improves the relative price competitiveness of a country’s tradables.
Real vs nominal metrics, and the breadth of coverage
The real exchange rate is distinct from the nominal exchange rate, which only reflects the price of foreign currency relative to domestic currency. To gauge a country’s competitiveness across its trading partners, economists also use the real effective exchange rate (REER), a weighted average of bilateral real exchange rates that accounts for trade shares. See Real effective exchange rate and Nominal exchange rate for related concepts. The broader literature also discusses terms of trade, which represent the price of a country’s exports relative to its imports and interact with the real exchange rate to influence welfare and growth.
Measurement and interpretation challenges
Measuring the real exchange rate involves choosing a price index for both domestic and foreign economies and selecting a method to combine price with the nominal rate. PPP-based interpretations can be informative over the long run but often provide a noisy signal in the short run, especially when markets exhibit structural frictions, non-tradables, or price rigidities. Price levels in tradable sectors tend to converge more quickly across countries than non-tradable prices, complicating simple comparisons. The literature emphasizes that real exchange rate movements reflect a mix of productivity differences, inflation dynamics, and policy credibility, rather than a single causal lever.
Theoretical foundations
Commodity and productivity channels: A key long-run driver of the real exchange rate is relative productivity growth, especially in tradable sectors. The Balassa–Samuelson effect posits that faster productivity growth in a country’s tradables raises wages in the non-tradable sector, pushing up the overall price level more than abroad and causing real currency appreciation. This framework helps explain why rapidly expanding economies may exhibit a stronger real exchange rate even as they gain in competitiveness in the tradable sector. See Balassa–Samuelson effect.
Inflation differentials and monetary policy: If a country runs higher inflation than its trading partners, its real exchange rate tends to depreciate in real terms, all else equal. Conversely, credible, low and stable inflation supported by a transparent and rule-based monetary framework tends to keep the real exchange rate aligned with fundamentals. In open economies, monetary policy autonomy is often traded off against exchange-rate stability, a choice central to discussions of the Floating exchange rate vs Fixed exchange rate regimes.
Terms of trade and external balance: Movements in commodity prices, import prices, and the terms of trade feed into the real exchange rate through their impact on domestic price levels and relative export competitiveness. A favorable terms of trade can permit a country to enjoy real depreciation (improved competitiveness) without complete wage or price adjustments, while an adverse terms of trade can push the real exchange rate higher.
Determinants and policy implications
Productivity and structural reform: In the long run, differences in productivity—especially in tradable sectors—are central to real exchange rate movements. Simultaneous investments in education, infrastructure, innovation, and institutions can translate into higher productivity and favorable shifts in the real exchange rate. See Productivity and Structural reform for related topics.
Inflation, credibility, and fiscal discipline: A credible monetary framework with disciplined fiscal policy supports predictable price levels, reducing unnecessary real misalignments. Central bank independence and transparent policymaking contribute to lower inflation differentials and a more stable real exchange rate, reinforcing a nation’s competitive position.
Exchange rate regimes and adjustment mechanisms: Flexible exchange rates can cushion domestic shocks by adjusting the real exchange rate through price and wage dynamics, while fixed or heavily managed regimes constrain this channel and require other stabilization tools. The choice between regimes often hinges on a country’s openness, financial market development, and vulnerability to external shocks. See Floating exchange rate and Fixed exchange rate.
Implications for trade and growth: A sustained, misaligned real exchange rate can affect trade competitiveness, import costs, and macro stability. Proponents of free trade and open capital markets argue that competitive pressures driven by markets—rather than interventions—toster the real exchange rate toward fundamental productivity gaps. Critics of excessive reliance on a single exchange-rate instrument emphasize the importance of structural reforms to avoid persistent misalignment and to support durable growth.
Controversies and debates
Long-run versus short-run determinants: The literature debates how much of the real exchange rate is driven by productivity differences versus monetary policy and demand conditions. While the Balassa–Samuelson mechanism has found empirical support in many growth episodes, others highlight that non-tradables and domestic demand can drive short-run fluctuations that are not tied to long-run productivity.
Policy credibility and misalignment: There is disagreement over how quickly real exchange rate misalignments correct. Some schools argue that markets efficiently reprice assets and prices as fundamentals shift, while others warn that rigidities, financial frictions, or policy errors can sustain misalignment and create adjustment costs.
Open economy policy trade-offs: Advocates of flexible exchange rates stress that real adjustments through price and wage changes can be less disruptive than policy interventions that deliberately alter the real rate. Critics, including some who emphasize distributional concerns, argue that depreciation can be painful for workers in non-tradable sectors or for those with debt denominated in foreign currency. From a market-based perspective, though, productivity and structural reforms are the durable remedy, whereas relying on currency moves alone risks cyclical volatility and misallocation.
Woke criticisms and counterpoints: Critics of market-based adjustment sometimes argue that free movement of capital or rapid depreciation can erode living standards, particularly for workers in sectors exposed to import competition. A right-leaning view would stress that the best protection for workers in the long run comes from increasing opportunities through productivity, mobility, and flexible labor markets, rather than relying on static protections or interventionist stances that dampen incentives for adaptation. Proponents of market-led adjustment contend that policy credibility, rule-based frameworks, and open competition deliver more durable gains in real income and living standards than short-run protectionist tactics.
See also