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Understanding Real Exchange Rate in a Country

The success of international trade and the foreign exchange market depends heavily on the concept of the real exchange rate. Real exchange rate (RER) is an economic model that describes how much of a good or service in a specific country can be exchanged for one unit of that good or service in another country (Catao). The real exchange rate seeks to quantify the value of goods and services in one country against another country’s current nominal rate. A mathematical representation of the real exchange rate involves multiplying a foreign price level ratio and the domestic price level with the nominal exchange rate.

R = (E.P*)/P

Where:

R is the real exchange rate

E is the nominal exchange rate

P* is the foreign price level

P is the domestic price level.

Looking at a practical example, if $1 is currently exchanging with €1.36, the nominal rate is 0.735 euros per dollar. When we choose a standard product and compare the prices between the domestic country U.S.A and one of the foreign countries in Europe, we can quickly determine the real exchange rate between them. If the real exchange is 1, the product will cost the same price in both countries when it is expressed with a common currency. It means that the chosen product will cost $1.36 in U.S.A and €1 in Europe respectively, hence the purchasing power parity of both the euro and the dollar are equal. Suppose the chosen product sells for €1.2 in Europe. It means that the development costs 20% more in Europe, thus suggesting the euro’s imminent overvaluation relative to the dollar. As a result, there is pressure on the nominal rate to adjust since the same product can be bought cheaply in one country than the other. Arbitrageurs can take advantage of such situations by buying dollars to purchase the product and later sell it to Europe. Consequently, the demand for dollars is set to rise together with the nominal exchange rate until equilibrium is achieved, and the RER returns to 1.

As Joao et al. (2020) indicate, RER is not restricted to one product but can also be used to compare many products when measured in terms of a broad perspective of the basket of goods. The fundamental laws governing RER dictate that currencies will face pressures to change when the RER diverges. Overvalued currencies are forced to depreciate, while undervalued currencies are forced to appreciate. However, unconsidered factors like government policies can hinder the normal equilibrium, thereby resulting to trade disputes.

Factors influencing relative exchange rates and relative currency prices.

The relative exchange rates and relative currency prices affect a country’s trading relationships with other countries. A higher-valued currency lowers the cost of imports while surging export costs, thereby discouraging exports and encouraging imports, respectively. A higher exchange rate worsens a country’s balance of trade while, on the other hand, a lower exchange rate improves the balance of trade in a country. Below are the factors that affect the exchange rate and currency prices of different nations (Twin).

• Inflation – Low inflation rates encourage exports while discouraging imports. As a result, a country experiences an appreciation in its currency value due to an increase in demand for the domestic currency. A good example is the German D-Mark’s long-term appreciation in the post-war era due to low inflation rates in the country.

• Interest rates – Central banks manipulate interest rates to influence the country’s inflation and currency values. Higher interest rates give the lenders of an economy higher returns. As a result, high-interest rates attract foreign capital, thereby causing a rise in exchange rates. Lower interest rates, on the other hand, tend to reduce exchange rates.

• Public debt – Large debts are a precursor to inflation. When inflation is high, the value of a currency is diminished, meaning that the debt is serviced with a cheaper currency. Moreover, if a government cannot service its debt through domestic means, it must increase the supply of securities, thereby lowering their prices.  Countries with huge public debts and deficits are less attractive to foreign investors, and thus it reduces foreign exchange.

• Terms of trade – This is the comparison between export prices and import prices relative to a county’s current accounts and balance of payments. Terms of trade are considered to be favorable if the exports of a country are higher than the imports. Favorable terms of trade provide an increased demand in the currency and an increase in the value of the currency, thereby increasing the country’s exchange rate.

• Economic growth and recession – Foreign investors actively seek out countries with stable and strong economic performance to invest their capital, thereby leading to an increased exchange rate. On the other hand, recession can cause a depreciation in the exchange rate due to reduced investors’ confidence.

The exchange rate and the value of a currency are dependent on suitable economic factors in a country. Favorable exchange rates indicate thriving economic conditions in a country, while poor exchange rates indicate a plummeting economy and a reduced currency value. Countries should seek to balance their balance of payment to achieve favorable exchange rates bound to attract foreign investors. Foreign investors are a vital part in determining a country’s relative exchange rate, where they tend to lean more to countries with a favorable economic environment.

Works Cited

Ayres, Joao, Constantino Hevia, and Juan Nicolini. “Real exchange rates and primary commodity prices.” Journal of International Economics (2020): 50-62. Document.

Catao, Luis. Real Exchange Rates: What Money Can Buy. 2020 February 2020. Website. 17 October 2020.

Twin, Alexandra. 6 Factors That Influence Exchange Rates. 3 April 2020. Website. 17 October 2020.