How to Calculate Real Exchange Rate with Inflation?

If you know how to calculate the real exchange rate of USD to CAD, you can quickly find out the purchasing power of your currency against another. An exchange rate is the rate at which an individual can exchange one currency for another at a particular time.

There are different types of exchange rates, including:

• Nominal Exchange Rate (NER): It is the amount of currency one can receive in exchange for another currency. Any change in price or value of goods and services doesn’t influence the nominal exchange rate.

• Real Exchange Rate (RER): It is the purchasing power of one currency relative to another currency at the current exchange rates and prices. In other words, any change in the prices or value of products can influence the real exchange rate.

• Real Effective Exchange Rate (REER): If you know how to calculate real effective exchange rate, you realize that REER is the weighted average of one currency against the index or basket of another significant currency.

In this guide, we focus on the basics of real exchange rates, including how it works. You will also learn how to calculate the real exchange rate with inflations.

Understanding the Basics of Real Exchange Rates

Simply put, the real exchange rate is the nominal exchange rate that considers the inflation differentials among different countries. Foreign investors and international businesses can use it as an indicator of a country’s foreign trade competitiveness.

Any change in the real exchange rates can result in fluctuations in short-term capital flows. The fluctuations will then affect the Bank of Canada’s net foreign assets. When the net foreign assets change in volume, it will result in changes in the volume of currency circulating on the liability side of the Bank’s balance sheet.

So, changes in the volume of currency in circulation will prompt the management of liquidity fluctuations in the economy. The Bank of Canada achieves that by utilizing its monetary policy tools, whose final objective is to ensure price stability. Since the real exchange rate plays a vital role in the economy, it’s one of the most debated topics.

How to Calculate the Real Exchange Rate

Typically, the real exchange rate (RER) is the relative price of goods in two countries, such as Canada and the United States. It is the rate at which Canadians can trade their goods for those of the United States.

The real rate is another terminology for the terms of trade, expressed as P_x/P_m, where P_m is the price of import and P_x is the price of export.

You can express the Real Exchange Rate (RER) as:

With this RER formula, it means that the rate at which one can exchange foreign and domestic goods will rely on two factors:

• The price of goods in local currency
• The rate at which an individual can exchange the two currencies.

Symbolically, you can express RER as:

e_r = e_n x (P/ P*)

Where:

• e_r is the real exchange rate (RER)
• e_n is the nominal exchange rate (NER)
• (P/ P*) is the ratio of the price level in the home country (P) to the price level in the foreign country (P*)

Pro Tip: A high RER implies that foreign goods are relatively cheaper while domestic goods are relatively expensive. On the other hand, a low RER means that the foreign goods are relatively expensive while the domestic goods are relatively cheap.

How the Real Exchange Rate Affects the Balance of Trade

Simply put, the real exchange rate is a relative price. It means that the relative demand for foreign and domestic goods get affected by the relative price of two groups of goods.

If the RER is low, the domestic residents (say, Canadian buyers) will buy a few imported (U.S.) goods. For the same reason, foreigners (say, U.S. buyers) will want to buy many domestic (Canada) goods. As a result, the demand for Canada’s net exports will rise.

Conversely, if the RER is high, domestic residents (Canadians) will want to purchase more imported goods while foreigners (U.S. residents) will want to buy a few Canadian goods. As a result, the quantity of U.S. net exports demanded will be very low.

The Definitions of Real Estate Exchange Rate

The real exchange rate definitions can primarily get categorized under two main groups:

• Purchasing power parity (PPP)
• Tradable and non-tradable goods

Purchasing Power Parity (PPP)

According to the PPP definition, the real exchange rate is the nominal exchange rate adjusted by the ratio of the foreign price level to the domestic price level.

Symbolically, it can be illustrated as:

Where:

• e is the nominal exchange rate
• P_f is the foreign price level
• P is the domestic price level
• r_ppp is the real appreciation of the exchange rate

Tradable and Non-Tradable Goods

This definition considers the relative price of tradable and non-tradable items in a country to indicate the competitiveness level in foreign trade.

The cost differential between two or more countries is closely linked with the relative price structures in the economies involved.

With an assumption that the prices of tradable goods will be the same globally, the real exchange rate defined based on tradable and non-tradable items can be expressed as:

Where:

• P_t stands for domestic prices of tradable goods
• P_t* stands for international prices of tradable goods
• P_n stands for the prices of non-tradable goods
• r_r indicates the real appreciation of a country’s domestic currency

The two definitions rely on the assumption that the domestic country has only one trading partner. But in the real world, that assumption doesn’t work. That’s where the real effective exchange rate that uses a weighting criterion comes in handy to help.

Final Words

Now that you know how to calculate real exchange rate, you’ll find it easy to determine your currency’s purchasing power relative to another currency. All you have to do is get the accurate figures for different variables used in the calculations. At Knightsbridge Foreign Exchange, we’ll help you get the best exchange rates to maximize your profit.