Calculating the real exchange rate

Economists and financial commentators often refer to the exchange rate when they discuss the economic situation. However, for each currency there are as many exchange rates as there are other currencies and it is difficult to judge which if any should be considered the most important. In this article we will show how it is possible to take data for individual exchange rates and construct an index which is economically meaningful. First we show how to average exchange rate data to construct a measure known as the effective exchange rate. This allows us to judge whether on average the pound has appreciated or depreciated relative to other world currencies. However, the effective exchange rate does not make allowances for differences in the price of goods between different countries. Therefore in the next section we show how we can make such an adjustment to obtain a measure known as the real effective exchange rate. In the final section this allows us to discuss the impact of the exchange rate on the level of international competitiveness and hence on the overall economy. All data in this article are taken from the IMF’s International Financial Statistics database.