That would mean it costs 20 percent more in the euro area, suggesting that the euro is 20 percent overvalued relative to the dollar. In this one-product world (in which the prices equal the exchange rates) the purchasing power parity of the dollar and the euro is the same and the RER is 1 (see box).īut suppose the burger sells for 1.2 euros in Germany. That would be the case if the Big Mac costs $1.36 in the United States and 1 euro in Germany (or any other European country using the euro).
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.
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. But if the German price were 3 euros and the U.S. If the German price is 2.5 euros and the U.S. The core equation is RER = eP*/P, where, in our example, e is the nominal dollar/euro exchange rate, P* is the average price of a good in the euro area, and P is the average price of the good in the United States. The real exchange rate (RER) between two currencies is the product of the nominal exchange rate (the dollar cost of a euro, for example) and the ratio of prices between the two countries. 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. Are they better off with dollars or euros? That’s where the RER comes in. The person or firm buying another currency is interested in what can be bought with it. But the nominal exchange rate isn’t the whole story. dollar holder $1.36 to buy one euro, from a euroholder’s perspective the nominal rate is 0.735 euros per dollar. It’s usually expressed as the domestic price of the foreign currency. Most people are familiar with the nominal exchange rate, the price of one currency in terms of another. 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). The United Kingdom never returned to the common currency.īut 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. 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. George Soros had the answer once-in 1992-when he successfully bet $1 billion against the British pound, in what turned out to be the beginning of a new era in large-scale currency speculation. How does one determine whether a currency is fundamentally undervalued or overvalued? This question lies at the core of international economics and many trade disputes. A real bargain (photo: Tim Graham/Corbis)
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