What is Real Exchange Rate

Real Exchange Rate, also called the Real Exchange Rate, is an exchange rate indicator that takes into account internal and external inflation.

Although it is not used as much as the nominal exchange rate, it is considered the best reference for the value of one currency in relation to another. In practice, it indicates the purchasing power of the currency of one country in relation to the currency of another.

Real Exchange Rate x Nominal Exchange Rate

 

The exchange rate normally disclosed is what we call the “nominal exchange rate”, which expresses the price of a currency. For example, if the nominal exchange rate of the Real against the Dollar is R $ 4.10, we know that it is necessary to pay R $ 4.10 to buy US $ 1.00.

However, the problem is that US $ 1.00 in the USA does not necessarily buy the same things that R $ 4.10 buy here in Brazil. Therefore, this nominal exchange rate is quite restricted.

Meanwhile, the real exchange rate is more useful and more complete, because it expresses the relationship of purchasing power between two currencies. That is, through this indicator, it is possible to know the correspondence between Dollar and Real to buy the same things in the USA and Brazil.

Calculation of the Real Exchange Rate

Although the concept seems complex, the calculation of the real exchange rate is relatively simple. Just apply the following formula:

R  = (C N x I E ) ÷ I I

Where:

  • is the Real Exchange Rate
  • Nis the Nominal Exchange Rate
  • Eis external inflation
  • Iis the Internal inflation

To better understand, let’s use an example. Suppose that the nominal exchange rate between Real and Dollar is R $ 4.10. Also, consider that inflation in the USA is 2% and, in Brazil, 4.25%.

In this case, the formula looks like this:

 = (4.10 x 0.02) ÷ 0.0425

 = 1.93

Therefore, the real exchange rate between Real and Dollar, in this scenario, is R $ 1.93.

Real Exchange Rate and Inflation

Some important relationships can be observed between the real exchange rate and inflation, internal or external.

First, the higher the domestic inflation, the lower the real exchange rate. This means that the Real is appreciating, causing the price of exported products to increase (which, of course, is not good for exports) and the price of imported products to fall.

Second, the higher the external inflation, the higher the real exchange rate. This means that the Real depreciates, causing the price of exported products to fall and the price of imported products to increase.

Effective Real Exchange Rate

The real exchange rate, as we have already seen, corrects the relationship between currencies taking inflation into account , so that it reflects the purchasing power of each one.

However, we can also use the effective real exchange rate, which considers one more element: the participation of each country in the flows of trade relations, that is, in the flows of exports and imports.

Equilibrium Real Exchange Rate

The real exchange rate, observed over a longer period, signals to economic agents whether it is profitable to produce and invest in a certain country, in view of its international competitiveness. Therefore, it is desirable to take this rate to a certain level and keep it under control.

This level is what we call the equilibrium real exchange rate. Determining what the level of this balance would be and what variables can be used to reach it is one of the debates of specialists in monetary exchange policies.

 

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