How do you truly know if a currency is undervalued or overvalued? This question is central to international economics, fuels numerous trade disputes, and is a key focus of the International Monetary Fund’s (IMF) monitoring efforts.
The dramatic events of 1992 offered a stark example. George Soros, a renowned financier, famously bet against the British pound, believing it was overvalued. His billion-dollar wager triggered a cascade, forcing the United Kingdom to exit the European Exchange Rate Mechanism (ERM), the precursor to the euro, and the pound never rejoined. This event underscored the power of currency speculation and the complexities of exchange rate valuation.
However, consistently replicating Soros’s success has proven elusive, and economists themselves haven’t discovered a definitive method to pinpoint a currency’s “correct” value. This is despite the exchange rate being a fundamental economic indicator and the existence of a powerful tool designed to provide insights: the real exchange rate (RER).
What Do Things Really Cost?
Most people are acquainted with the nominal exchange rate – the price of one currency in terms of another. It’s typically expressed as the domestic price to acquire foreign currency. For instance, if it costs $1.36 to purchase one euro, then from a euro holder’s perspective, the nominal rate is approximately 0.735 (1/1.36). This nominal exchange rate is what you see quoted for pairings like the Ft To Euro Exchange Rate or the dollar to yen exchange rate.
However, the nominal exchange rate doesn’t provide the complete picture. When individuals or businesses exchange currencies, their primary concern is purchasing power. Are they getting more value with dollars or euros? This is where the real exchange rate becomes crucial. The RER aims to compare the value of goods and services in one country relative to another, a group of countries, or the global average, using the prevailing nominal exchange rate.
Consider a simple illustration using a single, universally recognized product: the Big Mac. This McDonald’s sandwich has a remarkably consistent recipe across many nations. If the real exchange rate is 1, a Big Mac should cost the same in the United States as it does in Germany, when prices are converted to a common currency. This would occur if a Big Mac costs $1.36 in the U.S. and 1 euro in Germany. In this simplified scenario, where the Big Mac prices reflect overall price levels, the purchasing power parity (PPP) between the dollar and euro is equal, and the RER is 1. Economists refer to this condition as absolute PPP.
| Understanding the Real Exchange Rate |
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| The Real Exchange Rate (RER) between two currencies is calculated by multiplying the nominal exchange rate (e.g., the dollar price of a euro) by the ratio of price levels between the two countries. The formula is: RER = (e P) / P, where: e is the nominal exchange rate (dollar/euro). P** is the average price of a good in the euro area. P* is the average price of the same good in the United States. In our Big Mac example, if e = 1.36, the German price is 2.5 euros, and the U.S. price is $3.40, then RER = (1.36 2.5) / 3.40 = 1. However, if the German Big Mac price were 3 euros and the U.S. price remained $3.40, then RER = (1.36 * 3) / 3.40 = 1.2. |
Now, imagine the Big Mac sells for 1.2 euros in Germany instead of 1 euro. This indicates it’s 20% more expensive in the Eurozone, suggesting the euro might be 20% overvalued against the dollar. When the real exchange rate deviates significantly from parity, like in this case (1.2 instead of 1), it creates pressure for the nominal exchange rate to adjust. This is because the same product can be acquired more cheaply in one country than another.
This price discrepancy creates an arbitrage opportunity. Economically rational actors would buy dollars, use them to purchase Big Macs in the U.S. (equivalent to 1 euro), and then sell those Big Macs in Germany for 1.2 euros, profiting from the price difference. As arbitrageurs increase their demand for dollars to buy U.S. Big Macs for sale in Germany, the demand for dollars rises, pushing up the nominal exchange rate until the prices equalize and the RER returns to 1.
In reality, various factors complicate this simple price comparison. Transportation costs and trade barriers exist, hindering perfect price equalization. However, the core principle remains: significant deviations in RERs create pressure for currency adjustments. Overvalued currencies tend to depreciate, while undervalued currencies tend to appreciate. Government policies that interfere with the natural adjustment of exchange rates can further complicate this process, often becoming points of contention in international trade disputes.
Assessing Overvaluation and Undervaluation
How can we compare purchasing power when economies trade a vast array of goods and services, not just Big Macs? Economists typically use a broad basket of goods and services to calculate the real exchange rate. Since the price of this basket is usually represented by an index, such as the consumer price index (CPI), the RER is also typically expressed as an index, benchmarked to a specific time period.
Returning to our dollar-euro example, an RER index of 1.2 means that average consumer prices in Europe are 20% higher than in the United States, relative to the chosen base period. These indexes don’t measure absolute prices, like the Big Mac price, but rather track changes in overall prices compared to a base year. For instance, if the index is 100 in 2000 and 120 in 2007, average prices have increased by 20% since 2000. If RER indexes between countries remain constant over time, economists say that relative PPP holds.
Bilateral RER indexes, comparing two countries, can be insightful. The substantial U.S. trade deficit with China, for example, has become a major political and economic issue, and the question of whether a fundamentally misaligned exchange rate contributes to this deficit is hotly debated.
However, for a broader view of a currency’s overall alignment, economists and policymakers often focus on the real effective exchange rate (REER). The REER is a weighted average of a country’s bilateral RERs with its trading partners, where the weights reflect the proportion of trade with each partner. As an average, a country’s REER can appear to be in “equilibrium” (showing no overall misalignment) even if its currency is overvalued against some trading partners, as long as it’s undervalued against others.
To assess currency misalignment and its magnitude, examining REER trends over time is useful. Under both absolute and relative PPP, REERs should ideally remain stable over time if currencies are in equilibrium. However, consumption patterns, trade policies, tariffs, and transportation costs can change more rapidly than the statistical baskets used to calculate these indexes. Therefore, REER fluctuations don’t automatically signal fundamental misalignment.
Interestingly, despite significant reductions in transportation costs and tariffs over the last century and a greater convergence of national consumption patterns, REER fluctuations have actually increased. A century ago, REER fluctuations among advanced economies were typically within a 30% range. In the 1980s, the United States experienced REER swings as large as 80%! Other nations have witnessed similar volatility.
Navigating Complexities
It’s crucial to recognize that not all significant REER fluctuations indicate currency misalignment. Some substantial REER adjustments occur smoothly, suggesting factors beyond transportation costs, tastes, and tariffs are at play in influencing a currency’s REER without necessarily indicating misalignment.
Technological progress that boosts productivity in tradable goods sectors is considered one such factor. Increased productivity reduces production costs, leading to lower prices for tradable goods in the more productive country. This price reduction then spreads internationally through competitive pressures. However, not all goods are tradable. Nontradable sectors, such as housing and many personal services, experience minimal international price competition. Consequently, the prices of tradable goods tend to fall relative to nontradable goods. If nontradable goods constitute a significant portion of a country’s consumption basket, its CPI will rise relative to an international consumer basket, causing its REER to appreciate. This phenomenon is often called the “Balassa-Samuelson effect.” Both theoretical and empirical evidence suggest that variations in the prices of nontradables relative to tradables, particularly in developing countries, explain a considerable portion of REER fluctuations across countries.
Persistent shifts in a country’s terms of trade (as often seen in oil-producing nations) and differences in fiscal policies, tariffs, and even the level of financial market development can also contribute to cross-country REER differences. The IMF and economic analysts consider these real exchange rate fundamentals when estimating the “equilibrium” REER, which represents the level around which the actual REER should fluctuate in the absence of misalignment.
Estimating equilibrium REERs is challenging because prices tend to be somewhat sticky in the short term, while nominal exchange rates are not (especially in countries with market-determined exchange rates). This difference in adjustment speeds leads to considerable short-term volatility in REERs in response to news and market noise. It’s therefore not surprising that market participants and policymakers sometimes misjudge currency valuations, sometimes with serious consequences, as demonstrated by the 1992 ERM crisis. Despite their imperfections, REERs have proven to be valuable early indicators of significant exchange rate overvaluations preceding many financial crises, making it essential for institutions like the IMF to closely monitor both bilateral RERs and multilateral REERs.
Luis A.V. Cato is a Senior Economist in the IMF’s Research Department.
