Real exchange rate

Real exchange rate: Theoretical Approaches

Real exchange rate: Empirical Challenges

Real exchange rate: Measuring the Real Exchange Rate

The real exchange rate, a linchpin of international economics, tells us about the overall costs in one country compared with another. Defined as the cost of a bundle of goods in one country relative to the cost of the same bundle of goods in another country, it is conventionally written as the nominal exchange rate adjusted for international differences in prices levels:

Real Exchange Rate Nominal Exchange Rate Domestic Prices Foreign Prices ,

where the nominal exchange rate is specified here in terms of foreign currency units per unit of domestic currency.

Fromthis expression, one sees that if the nominal exchange rate fluctuates widely while the price indexes are relatively stable, then the real exchange rate will move with the nominal exchange rate. This indeed has been the pattern under floating exchange rates: real exchange rates havebeen nearly as volatile as nominal exchange rates have been.Moreover changes in the real exchange rate seemto persist for a very long time. Explaining the behavior of real exchange rates therefore requires both an understanding of why nominal exchange rates are so volatile under floating exchange rate arrangements and an understanding of what keeps prices from fluctuating proportionately.

See also Balassa-Samuelson effect; currency crisis; effective exchange rate; equilibrium exchange rate; exchange rate regimes; exchange rate volatility; New Open Economy Macroeconomics; purchasing power parity

FURTHER READING

• Cheung, Yin Wong, Menzie Chinn, and Antonio Garcia. 2005. ‘‘Empirical Exchange Rate Models of the 1990s: Are Any Fit to Survive?’’ Journal of International Money and Finance 24:7, 1150 75. UpdatesMeese and Rogoff (1983) and finds models to have limited and uneven empirical success.
•  Froot, Kenneth, and Kenneth Rogoff. 1995. ‘‘Perspectives on PPP and Long Run Real Exchange Rates.’’ In Handbook of International Economics, vol. 3, edited by Gene Grossman and Kenneth Rogoff. Amsterdam: Elsevier Science, 1647 88. Reviews empirical studies of real exchange rates, emphasizing tests of stationary and the Balassa Samuelson effect. 
• Meese, Richard, and Kenneth Rogoff. 1983. ‘‘Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?’’ Journal of International Economics 14: 3 24.The classic real exchange rate horserace, inwhich a random walk beats all. 
• Obstfeld, Maurice, and Kenneth Rogoff. 1995. ‘‘Exchange Rate Dynamics Redux.’’ Journal of Political Economy 103: 624 60. A pioneering piece in new open macro economics: combines dynamic optimization with im perfect competition and nominal rigidities in a single theoretical approach to modeling exchange rates and current accounts. 

HELEN POPPER