What is the Real Effective Exchange Rate?
The real effective exchange rate is a weighted average of the value of a country's currency relative to a basket of other major currencies, adjusted for differences in inflation. The real effective exchange rate often is used as a measure of the competitiveness of a country's exports. The real effective exchange rate is best understood by examining how it is different from other kinds of exchange rates.
The most fundamental exchange rate, often called the Foreign Exchange Rate, is the amount of one nation's money that can be obtained in exchange for a unit of another nation's money. Being able to convert one currency into another through a foreign exchange rate is what makes international trade possible. As with most issues in macroeconomics, it is common to adjust variables for the effects of inflation, and doing so with the foreign exchange rate yields the real exchange rate.
The real exchange rate is equal to the nominal foreign exchange rate adjusted for the difference in inflation between the two countries involved. This is determined by multiplying the foreign exchange rate by the ratio of the domestic price level to the foreign price level. The real exchange rate takes into account changes in the purchasing power of each currency because of inflation.
In the real world, countries do not have only one trading partner, so although individual exchange rates and real exchange rates between pairs of countries can be helpful, there are times when one might prefer to know the value of a country's currency relative to all of its trading partners. The effective exchange rate provides that information by weighting a country's exchange rate against an average of other currencies. The weight assigned to each currency usually, but not always, is determined by trade volume, with the most important trading partners receiving a higher weight.
The real effective exchange rate adjusts the nominal foreign exchange rate in both of these ways: accounting for a world where countries have more than one trading partner and adjusting for inflation. Calculating the real effective exchange rate begins by taking a country's nominal exchange rate with each trading partner and multiplying each by the ratio of domestic to foreign price levels, resulting in a collection of real exchange rates. Then, a weighted average of real exchange rates is calculated using the annual value of trade with each respective country or region as the weight. It usually is then converted to an index using a base period.
The article makes a good distinction about the definition of real effective exchange rate versus a direct currency conversion.
I think the former is important when trading goods and services. Some nations like China enjoy a trading advantage with the United States for this very reason.
I know that there are some populist politicians who argue that we should impose tariffs on Chinese imports, to undermine this currency advantage and make the U.S. more competitive. I’m kind of on the fence on those issues but I see their point. It’s hard to compete with countries who can make goods and services for pennies on the dollar.
@SkyWhisperer - I think the currency market is a gamble in its own right. Some traders treat currencies as commodities and trade them as you would shares of stock. They are trading on the Foreign Exchange Rate, of course, the direct currency conversion from one country to the next. It’s called the Forex exchange I believe.
I wouldn’t recommend that you participate however, because currency markets can fluctuate quite rapidly in response to market conditions, whether positive or negative. It’s virtually impossible, in my opinion, to anticipate which piece of news will pop up and sway the markets one way or another.
I think if you want to trade, stick with stocks and mutual funds. Currencies can collapse easily, as you point out. Stocks can collapse too, but many of them rebound if the company is strong. Currency devaluations can last much longer, and really be permanent.
I lived in Asia for four years and became very familiar with the concept of exchange rates. I taught in a school where I was paid in U.S. dollars and converted the money to local currency.
The dollar’s exchange rate to the local currency was very strong indeed, and so I lived well while I was there. This was quite amazing in itself, since the salary was not exactly high by U.S. standards. But for a developing country, it was quite good.
One year that nation’s currency collapsed because of an economic crisis. Suddenly the dollar pulled in 500% more against the nation’s currency than it did before.
The prices on goods and services had to be readjusted to reflect the new currency valuations. Some buyers who had U.S. dollars tried to capitalize on that brief window before the adjustments were made, and bought merchandise dirt cheap. I thought that was unethical; it was taking advantage of people's sufferings.
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