What is the real exchange rate and what drives its equilibrium level?

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AcadiFi · Accepted Answer

The real exchange rate is RER = S * P_foreign / P_domestic, where S is nominal rate (domestic per foreign), P is price level. It measures relative purchasing power. An RER above 1 means foreign goods are expensive; below 1 means domestic goods are relatively expensive.

Equilibrium RER depends on fundamentals: productivity differentials (Balassa-Samuelson: faster domestic productivity growth appreciates RER), terms of trade (commodity exporters see RER rise with commodity prices), net foreign assets position, fiscal stance, and long-run demographic trends. Capulet Emerging Markets models Brazil's RER around productivity growth, iron ore prices, and trade balance. When iron ore falls 20%, the equilibrium BRL/USD RER depreciates by about 8%.

Deviations from equilibrium RER are mean-reverting over 3-7 years. Overvaluation (RER above fundamental) signals expected depreciation; undervaluation signals appreciation. Central banks track RER indices (real effective exchange rate, REER) to gauge competitiveness. A 20% overvaluation historically precedes currency crises. For portfolio managers, RER deviations inform strategic tilts toward undervalued currencies, though persistence of deviations demands patience (and risk management).

What is the real exchange rate and what drives its equilibrium level?

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