The Real Exchange rate measures the value of a country’s goods against goods of another country, a group of countries, or the rest of the world at the prevailing nominal exchange rate. It can be measured between two countries in terms of a single representative product, for instance, a burger or a pizza sold in many countries in virtually identical versions. In this article, we will discuss the real exchange rate which is important for the UPSC examination.

What is Real Exchange Rate?

• The real exchange rate between two currencies is calculated by ascertaining the nominal exchange rate (e) multiplied by the ratio of prices between the two countries.
• If we are comparing the currency of country A relative to country B then the real Exchange rate is given by e x PA/PB; where PA is the price of a similar good in country A and PB is the price of a similar good in country B.
• It tells how many times a good and service can be purchased abroad (after conversion into a foreign currency) than in the domestic market for a given amount. It is a unitless entity.
• For instance, In the case of the Big Mac, we have a price (averaged across McDonald's restaurants) in India of about Rs 45 and a price (averaged across McDonald's restaurants) in the United States of about $5.30. (both as of July 2017). Take a dollar-Rupee exchange rate of 0.118 for the Big Mac in India. The RER is then calculated as 0.118 x 45/5.3, which equals 1. As a result, at the current dollar-rupee exchange rate, the rupee appears to be neither undervalued nor overvalued about the dollar.
• Take a look at the RER between China and the United States. Because one US dollar equals 6.8 yuan, the dollar-yuan exchange rate is 1/6.8, or 0.147. With an average Big Mac price in China of around 20, the burger's cost in US dollars (that is, e x P) is e x p = 20 x 0.147 = 2.94. Because the Big Mac costs $5.30, the RER of the yuan to the US dollar is 2.94/5.3 = 0.55. This is less than one, indicating that the yuan is undervalued. The RER is 45 cents short of one, implying that the yuan is 45 percent undervalued relative to the dollar.

Real Exchange Rate (RER) - Overview

• When the real exchange rate becomes overvalued, there is pressure on the nominal exchange rate to adjust, because the same goods can be purchased much cheaper in one country than in the other.
• For currencies that are overvalued the pressure is to depreciate and for currencies that are undervalued the pressure is to appreciate.
• It can also be influenced by policy changes that hinder the normal equilibration of exchange rates, which is often an issue in trade disputes.
• To measure the purchasing power when countries sell more than one product, the real exchange rate is measured in terms of a broad basket of goods.
• This is done because the price of such a basket takes the form of an index number like the consumer price index, which includes both goods and services.

Impact of RERs

• In RERs estimating equilibrium can be tricky because prices are somewhat sticky in the short run.
• Sometimes foreign exchange rates can also be held as a vehicle for speculation, this makes use of the real exchange rates difficult to ascertain misvaluation.
• If the real exchange rate rises it indicates that the goods are becoming more expensive relative to their competitors.
• An increase in the real exchange rate is also suggestive of the fact that people in a country can get more foreign goods for an equivalent amount of domestic goods.
• Sometimes increase in demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests, this leads to a decrease in RER.

Conclusion

The Real Exchange rate tells us how many times more or fewer goods and services can be purchased abroad (after conversion into a foreign currency) than in the domestic market for a given amount. It is mostly floating as even in the fixed nominal exchange rate, the real exchange rate can still move via price-level changes. It is regarded as a better measure to monitor the real exchange rate, especially when assessing the impact of exchange rates on the international trade or export competitiveness of a country.

GS Mains Questions and Model Answers

Q1: Examine the significance of the Real Exchange Rate in the context of India's trade balance.

Answer: The Real Exchange Rate (RER) plays a crucial role in determining India’s trade balance by influencing export and import levels. A depreciating RER enhances the competitiveness of Indian exports in the global market, potentially leading to increased export volumes, which is vital for India's economy. Conversely, an appreciating RER may render Indian goods more expensive internationally, reducing exports and increasing imports due to cheaper foreign goods. Consequently, the RER acts as a lever for trade policy, guiding decisions on tariffs, trade agreements, and currency interventions to achieve a favorable trade balance.

Q2: Analyze the factors influencing the Real Exchange Rate in India.

Answer: Several factors influence the Real Exchange Rate (RER) in India, including inflation differentials, interest rates, and economic policies. Inflation rates directly affect purchasing power; higher domestic inflation compared to foreign countries leads to a higher RER, making exports less competitive. Interest rates also play a critical role; higher rates tend to attract foreign capital, impacting the nominal exchange rate and subsequently the RER. Furthermore, government policies on trade and foreign exchange regulations can alter the RER by affecting supply and demand dynamics in the currency markets. These factors collectively determine India's position in global trade.

Q3: Discuss the impact of a fluctuating Real Exchange Rate on foreign investment in India.

Answer: Fluctuations in the Real Exchange Rate (RER) significantly affect foreign investment in India. A stable and favorable RER can attract foreign investors by providing a predictable environment for returns. A depreciating RER can increase the attractiveness of Indian assets, leading to higher foreign direct investment (FDI) as investors seek to capitalize on cheaper valuation. Conversely, if the RER appreciates, it can deter foreign investment due to increased costs and reduced competitiveness. Moreover, volatility in the RER creates uncertainty, making foreign investors cautious, potentially leading to decreased investment inflows. Therefore, maintaining a balanced RER is crucial for sustaining foreign investment levels.

Previous Year Questions on Real Exchange Rate

1. UPSC CSE 2017

Question: "Discuss the role of the Real Exchange Rate in shaping India's economic policies."

Answer: The Real Exchange Rate (RER) is pivotal in shaping India's economic policies, particularly in trade and monetary policy. A favorable RER supports export-led growth by making Indian goods competitive in global markets, aligning with policies aimed at boosting exports to improve the trade balance. Policymakers monitor the RER to address inflationary pressures and to stabilize the currency. Additionally, the RER informs decisions on foreign investment, guiding monetary interventions to ensure a stable investment climate. Therefore, the RER is integral to strategic economic planning, impacting employment, growth, and overall economic stability.

2. UPSC CSE 2020

Question: "Analyze the consequences of an appreciation of the Real Exchange Rate for the Indian economy."

Answer: An appreciation of the Real Exchange Rate (RER) can have significant consequences for the Indian economy. It generally indicates that domestic goods are becoming more expensive relative to foreign goods, leading to decreased export competitiveness. As exports decline, this can negatively impact industries reliant on international markets, potentially resulting in job losses and slower economic growth. Additionally, an appreciated RER can increase the volume of imports, exacerbating trade deficits and weakening domestic industries that compete with foreign products. While an appreciating RER may benefit consumers through lower prices for imports, its overall impact can challenge economic sustainability, necessitating policy measures to support affected sectors and restore balance.