Real Exchange Rate

The nominal exchange rate tells you how many units of one currency you can get for another. The real exchange rate also accounts for inflation, showing whether goods in one country have become more or less expensive compared with another.

For example, suppose one euro buys 1.10 US dollars and stays at that nominal rate for a year, while prices in the euro area rise by 5% and US prices rise by 2%. Euro area goods have become about 3% more expensive relative to US goods. In real terms, the euro has appreciated, even though the nominal rate is unchanged.

The real exchange rate is a better measure of competitiveness than the nominal rate. A rise in the real exchange rate makes a country's exports more expensive and imports cheaper, which can reduce net exports.

Economists often use a real effective exchange rate, which compares a currency against a weighted basket of trading partners' currencies, adjusted for inflation. The real exchange rate is linked to purchasing power parity, which suggests that over long periods real exchange rates tend to return to an equilibrium level.