The real exchange rate (RER) between two currencies is the product of the nominal exchange rate (the dollar cost of a euro, for example) and the ratio of prices between the two countries.
What is the purpose of the real exchange rate?
The real rate tells us how many times more or less goods and services can be purchased abroad (after conversion into a foreign currency) than in the domestic market for a given amount. In practice, changes of the real exchange rate rather than its absolute level are important.
What happens when real exchange rate increases?
An increase in the real exchange rate means people in a country can get more foreign goods for an equivalent amount of domestic goods. Therefore an increase in the real exchange rate will tend to increase net imports. Foreigners will buy our less expensive exports. It now becomes more attractive to buy imports.
What happens when the real exchange rate rises?
When the real exchange rate is high, the relative price of goods at home is higher than the relative price of goods abroad. In this case, import is likely because foreign goods are cheaper, in real terms, than domestic goods. Thus, when the real exchange rate is high, net exports decrease as imports rise.
What is the difference between real exchange rate and nominal exchange rate?
real exchange rate: The purchasing power of a currency relative to another at current exchange rates and prices. nominal exchange rate: The amount of currency you can receive in exchange for another currency.
What causes real exchange rates increase?
Interest rates, inflation, and exchange rates are all highly correlated. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.
What causes the real exchange rate to decrease?
If the price of a country’s exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. If the price of exports rises by a smaller rate than that of its imports, the currency’s value will decrease in relation to its trading partners.
