What is the Real Exchange Rate

The Real Exchange Rate is the relative value between the goods of one country and those of another; that is, it represents the price of the interest of one country concerning that of another different country, in such a way that the cost of both is transferred to a given currency through the foreign exchange rate.

In other words, the  exchange rate could be defined as the exchange ratio that represents the number of units of national product that can be purchased with each team of foreign product, that is, the real purchasing power of a currency in another country.

When the real exchange depreciates, few foreign goods are required to acquire a national interest. In turn, when the exchange rate is high, the opposite happens so that for the acquisition of a foreign good, many more national goods are required.

The real swap over rate variation can happen due to different factors. The following stand out: inflationary or deflationary effects in the market involved and the appreciation and depreciation of the local currency due to specific causes.

Similarities

Both concepts are used to perform economic analysis.

it concepts show relevant data for possible commercial movements.

Both the real exchange rate and the nominal exchange rate reflect how one currency can bought for another.

Economists use both concepts to compare parameters such as the cost of living in certain countries and convenience in acquiring goods, among others.

Differences

The main dissimilarity between the two concepts is that while the nominal exchange rate is the value of a particular currency concerning another, that is, the necessary amount of one cash to acquire another, the real exchange rate is the relative value between the goods of one country and those of another, that is, it represents the price of the interest of one country concerning another of a different country.

Their formulas are different and apply to know different values.

While the nominal exchange rate undergoes daily fluctuations, the real exchange  is relative since it considers purchasing power.

The Actual Exchange rate: Deepening the Concept

With the introduction to the fundamental concepts, we can understand the idea of the real exchange  well. By considering the prices of two places with different currencies, the real exchange rate adjusts the nominal exchange rate to the costs. Although later we will see a numerical example, a priori, several conclusions can reach.

The Nominal Exchange Rate is Equal to the Real.

If the nominal exchange rate is equal to the real exchange , the relative prices are the same. Although the prices are in dollars and another in pesos, it is equivalently the same in one place.

For example, for every dollar, they give us 30 Argentine pesos. So, for the nominal exchange rate to be equal to the real exchange , we should, on average, be able to buy the same thing with a dollar in the United States as with 30 pesos in Argentina. Continuing with the example, suppose that the reference price is coffee. So if in the United States, on average, coffee is worth one dollar, then in Argentina, on average, coffee is worth 30 pesos.

The Real Exchange is Higher than the Nominal.

If the real exchange  is higher than the nominal, it means that the prices of the reference currency are higher. In simpler words, my cash buys more things abroad than in my country. Let’s continue with the previous example and remember that they give us 30 Argentine pesos for every dollar. So with one dollar, you can buy more things in Argentina than with 30 pesos in the United States. Following the example of coffee. In the combined States, the price of coffee is worth 1 dollar, while in Argentina, it is worth 15 pesos. So actually, for every coffee we buy in the United States, we can buy two in Argentina.

The Nominal Exchange Rate is Higher than the Real.

If the nominal exchange rate is higher than the real one, it means that the prices of the reference currency are lower. Therefore, I buy less abroad with the same money as in my country. For example, for every dollar, they give us 30 Argentine pesos. Therefore, if the nominal exchange rate is higher than the real exchange rate, I buy fewer things with 1 dollar in Argentina than 30 pesos in the United States.

We have always taken the dollar as a reference in the previous examples. If we do the opposite, the conclusion will be the opposite.

Real Exchange example

To see it more clearly, we will perform a numerical example:

Suppose the existence of two countries, A and B. Both in-country and in-country B only cars produce. Of course, the price of a car is in its currency in each country. In country A, a vehicle costs 300 dollars. For its part, in country B, the price of the car is 6000 pesos

We can buy 1.5 times more than the pesos equivalent to a dollar in real terms. In other words, a car in country A is equal to 1.5 cars in country B. Even simpler, we can exchange two cars from country A for three cars from country B. In the calculation, we pass everything to the same unit (pesos). So a car in A is worth 9,000 pesos, and a vehicle in B is worth 6,000 pesos.