How Do You Calculate Real Exchange Rate

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Real Exchange Rate (RER) Calculator

Amount of foreign currency per 1 unit of domestic currency (e.g., 0.85 EUR per 1 USD).

Price index or price of a specific good in the home country.

Price index or price of the same good in the foreign country.

Understanding the Real Exchange Rate

While the nominal exchange rate tells you how many units of a foreign currency you can get for your domestic currency, it doesn't tell you how much you can actually buy with that money. To understand the true purchasing power and trade competitiveness between two countries, economists use the Real Exchange Rate (RER).

What is the Real Exchange Rate?

The Real Exchange Rate is the relative price of goods between two countries. It represents the rate at which you can trade the goods and services of one country for the goods and services of another. It effectively adjusts the nominal exchange rate for differences in price levels between the two nations.

The Real Exchange Rate Formula

RER = (e × P) / P*

Where:

  • e: The Nominal Exchange Rate (Foreign currency per unit of Domestic currency).
  • P: The Domestic Price Level (the price of a basket of goods in the home country).
  • P*: The Foreign Price Level (the price of the same basket of goods in the foreign country).

Practical Example: The Big Mac Index Logic

Imagine you want to compare the United States (Domestic) and the Eurozone (Foreign):

  1. Nominal Rate (e): 0.85 Euro per 1 USD.
  2. Domestic Price (P): A burger costs 5.00 in the USA.
  3. Foreign Price (P*): The same burger costs 4.50 in Europe.

Calculation: (0.85 × 5.00) / 4.50 = 4.25 / 4.50 = 0.944

In this case, since the RER is less than 1, the US dollar is "cheaper" in terms of goods than the Euro, meaning the domestic goods are more competitive globally.

Why Does RER Matter?

  • Trade Balance: A lower RER makes domestic goods cheaper for foreigners, typically increasing exports and decreasing imports.
  • Competitiveness: If the RER increases (appreciation), it means domestic goods have become more expensive compared to foreign goods, potentially hurting the local industry.
  • Inflation Impact: High domestic inflation (rising P) without a corresponding change in the nominal rate leads to a higher RER, making the country less competitive.
function calculateRER() { var e = parseFloat(document.getElementById('nominalRate').value); var p = parseFloat(document.getElementById('domesticPrice').value); var pStar = parseFloat(document.getElementById('foreignPrice').value); var resultDiv = document.getElementById('rerResult'); var valueDiv = document.getElementById('rerValue'); var interpDiv = document.getElementById('rerInterpretation'); if (isNaN(e) || isNaN(p) || isNaN(pStar) || e <= 0 || p <= 0 || pStar 1) { interpretation = "The Real Exchange Rate is greater than 1. This suggests that domestic goods are more expensive than foreign goods. The domestic currency has higher purchasing power abroad than at home."; } else if (rer < 1) { interpretation = "The Real Exchange Rate is less than 1. This suggests that domestic goods are cheaper than foreign goods, making domestic exports more competitive in the global market."; } else { interpretation = "The Real Exchange Rate is exactly 1. This represents Purchasing Power Parity (PPP), where the same amount of currency buys the same volume of goods in both countries."; } interpDiv.innerHTML = interpretation; }

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