Definition
Real Exchange Rate
The real exchange rate adjusts the nominal exchange rate for inflation differences between two countries, measuring the true relative price of goods across borders.
The real exchange rate tells you how many baskets of foreign goods one basket of domestic goods buys, factoring in both the nominal rate and price levels. A rising real rate means domestic goods are getting relatively more expensive abroad.
It is the bilateral cousin of the trade-weighted REER. Even if USDINR is flat, higher Indian inflation than US inflation makes the rupee appreciate in real terms, eroding export competitiveness, a key concern for policymakers.
Related terms
- Real Effective Exchange Rate (REER)REER is a trade-weighted index of a currency against a basket of partner currencies, adjusted for inflation differences, measuring true competitiveness rather than a single bilateral rate.
- Nominal Effective Exchange Rate (NEER)NEER is a trade-weighted average of a currency's value against a basket of partner currencies, measured without adjusting for inflation, capturing the rupee's broad nominal strength.
- Purchasing Power Parity (PPP)Purchasing power parity holds that exchange rates should equalise the price of an identical basket of goods across countries, so a currency's true value reflects what it can buy.
- Balassa-Samuelson EffectThe Balassa-Samuelson effect explains why prices and real exchange rates tend to be lower in poorer countries, because productivity gaps are larger in traded than non-traded sectors.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.