Glossary

Real exchange rate

The real exchange rate between two currencies combines the nominal exchange rate with the ratio of the price of goods or services in two different countries.

The currency exchange rates that we see and use every day are nominal exchange rates. They tell us what we get if we swap a unit of one currency for another – for example, a pound-dollar exchange rate of $1.25 means that we get 1.25 dollars for every pound. This is all that matters if we are buying something from abroad or sending money internationally. But it doesn’t tells us everything we want to know about the value of different currencies. 

For more insight into this, we can use the real exchange rate (RER), which combines the nominal exchange rate with the ratio of the price of goods or services in the two countries. Say that a burger costs $5 in the US, but £3 in the UK. Then the real pound-dollar exchange rate based on burger prices is 1.25×(3÷5)=0.75. This is lower than one, which says the pound is undervalued (the RER will be one if the burger costs the same in both countries once both exchange rates and local prices are taken into account). 

In practice, a real exchange rate is calculated by using the price of a basket of goods and services (eg, a consumer price index) not one item. And we consider the trend in the RER index over the long term, rather than at a single point in time. Due to frictions such as trade barriers, transport costs or local taxes and their effect on price, the RER between two countries might persistently be higher (or lower) than one and what really matters is whether it is much higher or lower than usual.

We are often interested in how cheap or expensive a currency is on a global basis. For this, we can consider its effective exchange rate (EER), which is an index that measures the nominal value of a currency against a basket of other currencies (eg, a country’s major trading partners). The real effective exchange rate (REER) is an index calculated in the same way using RERs and provides a measure of a country’s competitiveness. A low REER means its exports should be more competitive on price.

Recommended

Resource curse
Glossary

Resource curse

The term “resource curse” refers to the observation that countries with abundant natural resources also tend to be less economically developed than th…
14 Jan 2021
Balance of payments
Glossary

Balance of payments

The balance of payments refers to the accounts that sum up a country's financial position relative to other countries.
8 Jan 2021
Yield-curve control
Glossary

Yield-curve control

Yield-curve control is when a central bank aims to control long-term interest rates by pledging to buy (or sell) as many long-term bonds as needed to …
25 Dec 2020
Intangible assets
Glossary

Intangible assets

An intangible asset is anything that a company owns that isn’t physical.
25 Sep 2020

Most Popular

Are we heading for another bond market tantrum?
Government bonds

Are we heading for another bond market tantrum?

The last time the US central bank tried tightening the purse strings, the bond markets threw a tantrum. With yields now rising, could we be about to s…
25 Feb 2021
Expect more turbulence as the market calls central bankers’ bluff
Stockmarkets

Expect more turbulence as the market calls central bankers’ bluff

With bond yields climbing and stockmarkets sliding, markets are hoping central bankers will step in again to repress interest rates – but that won’t …
26 Feb 2021
Invest in water and provide a buffer against future pandemics
Soft commodities

Invest in water and provide a buffer against future pandemics

Global water shortages have long hampered growth and development, and climate change has exacerbated the problem. Will the coronavirus pandemic be a t…
25 Feb 2021