Going back to the dollar-euro example, if the RER index is 1.2, average consumer prices in Europe are 20 percent higher than in the United States, relative to the chosen benchmark.
Consider the case of Germany relative to the United States. Unlike most other real variables, this adjustment requires accounting for price levels in two currencies. In the Big Mac example, we have a price (averaged across McDonald’s restaurants) in Germany of about €4.50 and an average price in the United States of about $5.30 (both as of July 2017). The Real Exchange Rate: The real exchange rate (RER) refers to the relative price of goods of Britain and USA. Those variables can be defined so that a rise in the RER denotes appreciation (as the IMF typically does) or depreciation (as many economics textbooks do). This makes it even harder to use RER computations such as illustrated above—based on the relative prices of two goods or baskets of goods—to gauge misvaluation.
An appreciated exchange rate may favor production of nontradable goods and imports. The real exchange rate can be calculated between only two countries (bilateral real exchange rate), but we can also take multiple countries into account (multilateral real exchange rate). That can lead to massive realignments with devastating consequences.
The RER therefore is eP*/P. RER indices between two countries can be important.
Indeed, it would make economic sense to buy dollars, use them to buy Big Macs in the United States at the equivalent of about 1 euro, and sell them in Germany for 1.2 euros.
Technology changes that cause productivity increases in goods commonly traded between countries, called tradables, are thought to be one of those factors. As arbitrageurs buy dollars to purchase Big Macs to sell in Germany, demand for dollars rises, as does the nominal exchange rate, until the price in Germany and the United States is the same—the RER returns to 1.
Indices don’t measure absolute prices (such as the price of the Big Mac), but changes in overall prices relative to a base year.
This is why the IMF and others should closely monitor bilateral real exchange rate and multilateral real effective exchange rate indicators. The real exchange rate measures the price of foreign goods relative to the price of domestic goods.
With an average Big Mac price in China of about ¥20, the cost in US dollars of the burger in China (that is, e x P) is e x p = 20 x 0.147 = 2.94.
The Excel RATE function is a financial function that returns the interest rate per period of an annuity. (If, say, the index is 100 in the year 2000 and 120 in 2017, average prices are 20 percent higher in 2017 than in 2000.) That is, variations in tariffs and transportation costs don’t shift goods prices as much as in the past, yet REERs have been moving about by quite a bit over the past three or four decades.
Because the price of such a basket normally takes the form of an index number—such as the consumer price index, which includes both goods and services—the RER is also typically expressed as an index that can be benchmarked to any chosen time period. For overvalued currencies the pressure is to depreciate and for undervalued currencies to appreciate.
The real exchange rate (RER) between two currencies is the nominal exchange rate (e) multiplied by the ratio of prices between the two countries, P/P*. This question lies at the core of international economics and many trade disputes.George Soros had the answer once—in a famous episode back in 1992—when he successfully bet $1 billion against the British pound, in what turned out to be the beginning of a new era in large-scale currency speculation. So, at the current dollar-euro exchange rate, the euro appears neither undervalued nor overvalued relative to the dollar. It's the price of a The real exchange rate can vary if there are changes in:If the real exchange rate rises, it means that we need more local goods to purchase the same amount of foreign goods: foreign goods have become more expensive in term of local goods.
For the Big Mac in Germany, take a dollar-euro exchange rate of 1.18.
As with the absolute and relative RERs, there should be no changes if the currencies are in equilibrium. Let’s define the RER so that a rise denotes appreciation of Germany’s real exchange rate. We can also use the GOOGLEFINANCE function to pull the exchange rates for the last N days (10 days in the formula below): =GOOGLEFINANCE("CURRENCY:USDEUR","price",TODAY()-10,TODAY()) Get exchange rates …