A Note on the Real Currency Exchange Rate: Definitions and Implications

Abstract

The real exchange rate (RER) in the literature is defined as the relative national price levels between two economies with the corresponding nominal exchange rate being an auxiliary to convert the unit of account such that two price levels are measured in a single currency. Its subject is not the currency or exchange rate, but the relative cost of living between two economies.This note proposes to define the real exchange rate of a currency as the nominal exchange rate adjusted for relative purchase power. It measures how much the currency can purchase in real terms, or the purchase power of the currency abroad relative to that at home. In this definition, the subject is the currency which serves as medium of exchange. It implies that its measure should be asymmetric; the price at home is broad like CPI, but the price abroad is only for imports. It is hypothesized that the RER with this medium-of-exchange feature is expected to be more relevant to exchange and hence the trade balance.