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I am struggling with something as simple as real exchange rate calculation!

I get the theory: RER = NOM * (P*/P) i.e. nominal exchange rate times price level ratios. Apparently, using CPI (consumer price index) is common practice for P.

I have the nominal exchange rate and I have both CPI for country A and country B as index 100=2005.

What I don't understand is that in 2005, the nominal rate = real exchange rate. But that makes sense only because of the 2005 index - not in the real world. What am I doing wrong?

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  • you cannot compute real exchange rates based on the data you have. What you can do, and what is often done (not sure what it is good for though) is to use relative PPP to calculate changes in RER using some base year.

  • The OECD publishes some statistics on P*/P, you could also use that, although I am not sure what methodology they use.

  • In practice, you would need the actual prices of a basket of goods to calculate the RER, once you somehow normalize prices within a country you can no longer calculate the RER.

  • hence the appeal of stuff like the Big Mac Index.

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  • $\begingroup$ Thanks! I kind of thought this would be the case. The paper I am following says they use nominal exchange rate deflated by CPI in both domestic and foreign country. I don't understand how they go about it... $\endgroup$ – Karel Apr 6 '17 at 19:56

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