Why Real Exchange Rates?

Author:Luis A.V. Catão
Position::Senior Economist in the IMF's Research Department

What things really cost. Overvalued or undervalued?. Tough calls.


HOW does one determine whether a currency is fundamentally undervalued or overvalued? this question lies at the core of international economics, many trade disputes, and the new IMF surveillance effort.

George Soros had the answer once-in 1992-when he successfully bet $1 billion against the pound sterling, in what turned out to be the beginning of a new era in large-scale currency speculation. Under assault by Soros and other speculators, who believed that the pound was overvalued, the British currency crashed, in turn forcing the United Kingdom's dramatic exit from the european exchange Rate Mechanism (eRM), the precursor to the common european currency, the euro, to which it never returned.

But in the ensuing years, neither Soros nor fellow speculators have repeated the feat consistently, and the economics profession itself lacks a foolproof method of establishing when a currency is properly valued. This failure is striking given that the exchange rate is a central price in economics and that there is a measure potentially capable of delivering the answer and for which plenty of data exist: the real exchange rate (ReR).

What things really cost

Most people are familiar with the nominal exchange rate, the price of one currency in terms of another. It's usually expressed as the domestic price of the foreign currency. So if it costs a U.S. dollar holder $1.36 to buy one euro, from a euro holder's perspective the nominal rate is 0.735. But the nominal exchange rate isn't the whole story. The person, or firm, who buys another currency is interested in what can be bought with it. Are they better off with dollars or euros? that's where the ReR comes in. It seeks to measure the value of a country's goods against those of another country, a group of countries, or the rest of the world, at the prevailing nominal exchange rate.

One can measure the real exchange rate between two countries in terms of a single representative good-say, the Big Mac, the McDonald's sandwich of which a virtually identical version is sold in many countries. If the real exchange rate is 1, the burger would cost the same in the United States as in, say, Germany, when the price is expressed in a common currency. That would be the case if the Big Mac costs $1.36 in the United States and 1 euro in Germany. In this one-product world (in which the prices equal the exchange rates), the purchasing power parity (PPP) of the dollar and the euro is the same and the ReR is 1 (see box). In this...

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