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Real Exchange Rate Definition and Formula

If you are looking for real exchange rate definition, keep reading. It refers to the comparison of the relative price of consumption baskets of two countries. In calculating the RER, it is essential to know two things: the price of consumption baskets of two countries and the nominal exchange rate. Continue reading to learn where to get economics assignment answers today!

real exchange rate definition

Short History about Real Exchange Rate

The real exchange rate of 2 currencies is the nominal exchange rate of product and the ratio of prices between 2 countries where the core real exchange rate formula is RER=eP*/P.

A real exchange rate is the nominal rate of exchange adjusted or changed for inflation. Versus other variables, the adjustment needs looking into the level of prices in two currencies. The RER is RER=eP*/P, where the E means “nominal domestic currency price” of the foreign currency while the P means the “domestic price level.” Also, the P* means the foreign price level. The Real exchange rate also means the real price of the foreign goods such as domestic goods quantity that is needed in purchasing a foreign goods unit.

Calculating the Real Exchange Rate

Mathematically, the real exchange rate is equal to the nominal exchange rates multiplied by the domestic price of the item and then divided by the foreign price of the item. This real exchange rate formula is essential to know because the calculation results in a foreign item per unit of the domestic good. In other words, RER measures the currencies’ value, taking into consideration the change in the price level. The RER shows what you can buy because it’s the value consumers that will pay for the good.

Formula: RER = E.R *(price level in country A/Price level in country B)

real exchange rate formula

To understand it more, knowing real exchange rate example is important. Additionally, in calculating the real exchange rates, it is likely based on a basket of goods than a single homogenous commodity. The price indices in countries are being used such that:

εr = e.r.nominal[CPIdomestic / CPIforeign]

real exchange rate definition and formula

For example:

Imagine two currencies, which are B and C. Let us say it is happening in the open market, wherein two B’s can buy only one C. In this case, the nominal exchange rate “would be B/C 2,” meaning two As would buy B, wherein the exchange rate can be written as C/B 0.5.

Note: This example applies the formula of the real exchange rate.

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