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.
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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.
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