# real exchange rate appreciation

i find the topic of real exchange rate appreciation / depreciation often not very well explained.

even the excerpt below from the following accepted answer on this website is not correct in my opinion.

The home currency appreciates in real terms against a foreign currency either if the home currency appreciates in nominal terms or if the home country's inflation rate is lower than that in the foreign currency.

specifically, the part in bold i believe is wrong. if the home country's inflation rate is lower than that of the foreign country, then all else equal, the home currency should depreciate in real terms as the domestic consumption basket becomes cheaper relative to the foreign consumption basket

some of the confusion abounds because of the different quoting conventions (X vs 1/X, foreign vs domestic, etc)

You need a clear understanding of what is exchange rate and how it is determined.

Consider two countries with free flow of goods and services that is there is no transaction, transportation, tariff costs etc. [I am assuming an ideal world here].

say,

India (Currency: Indian Rupee abbreviated as INR) and USA (Currency: Dollar abbreviated as $). Exchange rate:$ 1 = INR 50

Consider a commodity let us say pencils:

Assume that in year 2018 - one pencil costs $1 in USA and INR 50 in India. Now let us suppose that India faces an inflation of 10% per annum and there is no inflation in USA. Hence new prices of pencil in year 2019: India - INR 55 USA -$ 1

Since, there are no transportation and transaction costs Indians will start purchasing pencil from USA since 1 US $still equals INR 50 and Indians get pencils relatively cheaper in USA after converting their currency into dollars. This will push up Indian imports and hence Indian currency will depreciate and US dollar will appreciate because US exports have gone up. This process will continue till 1$ = INR 55.

Now coming back to your question say home country is USA and due to relatively lower inflation rate in USA, the US dollar appreciates (NOT depreciate).

• nicely written :) – Guy Louzon Sep 26 '18 at 18:06
• maybe there is a confusion about step 1 and step 2 in your well-written answer. i think the original poster is suggesting that as of the state where pencils cost 55 INR and 1 USD, the INR has appreciated on a real basis. i believe what you describe is a subsequent nominal depreciation – laszlopanaflex Sep 27 '18 at 19:14
• A decrease in purchasing power of currency would always cause a depreciation in currency in an Open barrier-less Economy. I think you are confused between changes in price level and exchange rate. The exchange rate is determined by the equilibrium of demand and supply of the foreign currency. Hence, the exchange rate has nothing to do with the domestic purchasing power of the currency unless it is traded for the foreign currency. Think of it this way, if Indian government follows protectionist policies for pencil industry and bans the import of pencils, the Indian Rupee will never depreciate. – DrStrangeLove Sep 28 '18 at 13:22
• take a look at this link: quora.com/…. – laszlopanaflex Sep 28 '18 at 19:13

If, as you say, the domestic consumption basket becomes cheaper, that means that the purchasing power of the domestic currency has increased. If the purchasing powes of the domestic currency has increased while that of the foreign currency hasn't changed, the domestic currency has appreciated in real terms.