Real Effective Exchange Rate Calculation Example

What is Real Effective Exchange Rate?

The Real Effective Exchange Rate (REER) is a key concept in international economics that combines the nominal exchange rate with price differences between countries. Unlike the nominal exchange rate, which only considers the value of one currency in terms of another, the REER accounts for differences in the cost of living between countries.

This adjustment is crucial because it allows for a more accurate comparison of the relative purchasing power of goods and services between countries. A lower REER indicates that a country's goods and services are relatively cheaper compared to another country, making it more competitive in international trade.

Formula

The formula for calculating the Real Effective Exchange Rate is:

Where:

• Nominal Exchange Rate - The current exchange rate between two currencies
• Price Index of Country A - A measure of the average price level of goods and services in Country A
• Price Index of Country B - A measure of the average price level of goods and services in Country B

The REER is typically expressed as a ratio, where a value of 1 indicates that the purchasing power parity is maintained between the two countries.

Calculation Example

Let's look at an example to illustrate how to calculate the Real Effective Exchange Rate. Suppose we have the following data for two countries, Country X and Country Y:

• Nominal Exchange Rate (X/Y): 1.20
• Price Index of Country X: 100
• Price Index of Country Y: 120

Using the formula:

In this case, the REER is approximately 1.00, which suggests that the purchasing power parity is maintained between Country X and Country Y.

This example demonstrates how the REER can be used to assess the relative competitiveness of countries in international trade. A REER of 1.00 indicates that the goods and services of both countries are priced at similar levels, taking into account both the nominal exchange rate and price differences.

Interpretation

Interpreting the Real Effective Exchange Rate requires understanding how it relates to purchasing power parity and international trade competitiveness. Here are some key points to consider:

• REER = 1.00: Indicates that the purchasing power parity is maintained between the two countries. Goods and services are priced at similar levels, taking into account both the nominal exchange rate and price differences.
• REER > 1.00: Suggests that the goods and services of Country A are relatively more expensive compared to Country B. This could indicate a lack of competitiveness in international trade.
• REER < 1.00: Indicates that the goods and services of Country A are relatively cheaper compared to Country B. This suggests a higher level of competitiveness in international trade.

Understanding the REER is essential for businesses and policymakers looking to assess the competitiveness of their country in international trade. By accounting for both the nominal exchange rate and price differences, the REER provides a more accurate picture of a country's position in the global economy.