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).

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