Countries Using Currencies Other Than the Euro and Peso
The real exchange rate (RER) measures a country’s goods’ value against those of another country, group of countries, or the rest of the world at the prevailing exchange rate. It helps determine if a currency is undervalued or overvalued. The nominal exchange rate, the price of one currency in terms of another, doesn’t tell the whole story. The RER considers what can be bought with a currency, indicating whether consumers are better off with, for example, dollars or euros.
The RER is calculated by multiplying the nominal exchange rate by the ratio of prices between two countries: RER = eP/P. For instance, if the dollar/euro exchange rate (e) is 1.36, the average price in the euro area (P) is 2.5 euros, and the average U.S. price (P) is $3.40, the RER is 1. A RER of 1 means a good costs the same in both countries when expressed in a common currency. However, if the German price were 3 euros and the U.S. price $3.40, the RER would be 1.2, indicating the euro is 20% overvalued relative to the dollar.
A simple illustration uses the Big Mac Index, comparing the price of a Big Mac across countries. If the RER is 1, the burger costs the same in both countries. A higher RER suggests the foreign currency is overvalued. Arbitrage, exploiting price differences, would then push the nominal exchange rate to adjust until the RER returns to 1. Real-world complexities like transportation costs and trade barriers affect this simplified model.
When comparing multiple products, economists use a broad basket of goods and express the RER as an index. An RER index of 1.2 signifies that average consumer prices in Europe are 20% higher than in the U.S. relative to a benchmark year. While bilateral RERs are important, the real effective exchange rate (REER) is more commonly used. The REER averages the bilateral RERs between a country and its trading partners, weighted by trade shares. A country’s REER can be in equilibrium even if its currency is overvalued against some partners and undervalued against others.
REER fluctuations have intensified despite decreased transportation costs and tariffs. Factors beyond these, such as technology-driven productivity increases in tradable goods, influence REERs. Productivity gains lower production costs, requiring REER adjustments to maintain equilibrium. Nontradable goods like housing and services, less subject to international competition, can have widely varying prices. These fluctuations in nontradable prices significantly contribute to REER variations across countries.
Other factors affecting REERs include changes in terms of trade, fiscal policies, tariffs, and financial development. The IMF considers these fundamentals when estimating the equilibrium REER. Estimating equilibrium RERs is challenging due to short-term price stickiness and nominal exchange rate volatility. This can lead to miscalculations and significant realignments with severe consequences. Despite imperfections, REERs have predicted overvaluations before financial crises, highlighting the importance of monitoring RERs and REERs for economic stability.