The real exchange rate (RER) measures the actual price of goods and services between two countries. It adjusts the nominal exchange rate by accounting for differences in inflation, showing the true purchasing power of one currency compared to another.

Key features:

• Formula: RER = Nominal exchange rate x (Price level in domestic country / Price level in foreign country)
• An increase means domestic goods are cheaper abroad, which helps export competitiveness.
• A decrease means domestic goods are more expensive, which hurts export competitiveness.
• It is a more accurate way to measure international competitiveness than using the nominal rate alone.
• It helps explain trade flows and current account balances.

When inflation levels are similar between countries, the nominal and real exchange rates move together. However, when inflation rates are very different, the real exchange rate gives a much clearer view of a country’s economic health.