Real exchange rate: Measuring the Real Exchange Rate
Real exchange rate: Theoretical Approaches
Real exchange rate: Empirical Challenges
Empirical work on real exchange rates involves many judgments about how to construct real exchange rate measures. Most important, appropriate price indicators and suitable aggregation methods must be selected. Typically, price indexes, such as the consumer price index or the producer price index, are used. Just as those indexes show price changes rather than price levels, real exchange rates so constructed will gauge real exchange rate changes, rather than their levels. These measures tell us what the real appreciation or depreciation has been relative to some point in time, but they do not provide the real exchange rate’s actual value. Calculation of the real exchange rate’s level requires information about price levels, information that is not always readily available. Such distinctions between indexes and levels can be important in debates about exchange rate policies and trade policies. For example, an index can tell how much the value of the Chinese currency has changed since theAsian financial crisis in 1997 98, but only a measure of the real exchange rate’s level can tell us if it is weak or strong relative to another currency or relative to a theoretical value.
One also faces the question of what categories of prices to use. Consumer prices are used most often. Producer and wholesale price indexes, and even export price indexes, are sometimes chosen over the consumer price index because they better represent the notion of export competitiveness, which often is of particular interest. As the set of prices narrows increasingly toward including only actually traded goods, however, it also becomes increasingly like a measure of the terms of trade the relative price of imports and exports and less a measure of the real exchange rate.
Finally, since currency values so often diverge, real exchange rate measures can be sensitive to the set of countries included and to their weights. A country’s real exchange rate often is measured bilaterally, that is, against only one other country. A broader multilateral measure can differ markedly from a bilateral one, however. For example, a country that pegs its nominal exchange rate against that of a single trading partner is likely to have a relatively stable bilateral real exchange rate against that country. Against other countries, however, its real exchange rate could be very unstable, either rising or falling. A multilateral or effective real exchange rate will capture those broader movements.
Whether one is interested in questions about the fundamental determinants of the real exchange rate or has questions about the experience or policies of a single country, all of the measurement choices affect the measures and thereby shape the conclusions.