All About Real and Nominal Exchange Rates

The rupee has appreciated sharply against the dollar in the last few months, raising some concerns, especially among exporters. These exchange rate index are quite similar to a stock market index.  Several key issues  are considered for actual calculation for example, export competitiveness. The real issue, economists say, is not the exchange rate as we know, or the nominal exchange rate, but the effective exchange rate.

What do ‘real’ numbers mean?
The word ‘real’ in economics -- as opposed to ‘nominal’ -- is used to describe a metric, where the impact of prices has been taken into account. For example, real GDP captures output of goods and services at constant prices, removing the effect of inflation.

What is real exchange rate?
Real exchange rate can be defined as the rate that takes into account inflation differential between the countries. Suppose the rupee was trading at . 40 to a dollar at the beginning of 2009. Assuming a 10% inflation in the Indian economy and 5% inflation in the US economy for the whole year, then this model says the rupee should depreciate by 5% (10%-5%) to . 42 to a dollar, other things being equal.

Why is the real exchange rate important?
Competitiveness of a country’s exports is decided not only by the nominal exchange rate, but also relative price movements in domestic and foreign markets. For instance, even if the nominal exchange of the rupee remains unchanged with respect to, say, the dollar, India’s exports to the US will become less competitive if inflation in India is higher than in the US. This means nominal exchange rate will have to be adjusted for effect of inflation.

How is nominal exchange rate adjusted for inflation?
Central banks use the concept of ‘real effective exchange rate’, or REER, to adjust nominal effective exchange rate for inflation. Conceptually, the REER is the weighted average of nominal exchange rates adjusted for the price differential between the domestic and foreign countries. The price differential, however, is based on the purchasing power concept. The currencies used are of those countries with which trade is the highest.

How does the RBI calculate REER?
The RBI calculates REER for India. It calculates the value of the rupee with respect to two indices, one comprising six countries and the other 36 countries with a 2004-05 base. The RBI, however, uses the wholesale price index-based inflation whereas globally consumer price indices are used. One conceptual flaw with this model is that it assumes that the base exchange rate is the correct exchange rate or represents the purchasing power parities accurately, which may not be the case.

source : Economic times