Real exchange rate measurements and determinants.
Real exchange rate is regarded as an important economic issue, which interacts with the economy growth of a country. It relates to the nominal exchange rate and relative price both in home country and foreign country (Ellis, 2002). It is worthwhile to analyze how it is measured and how it is determined in the real economic circumstances. On the basis of some recent relevant researches, this paper will discuss three main features of real exchange rat, that is, the definition, the measurements and determinants.
Definition of Real Exchange Rate.
By definition, real exchange rate refers to the price of foreign goods exchanged into a domestic currency relative to the price of domestic goods (Ellis, 2002). In order to calculate it simply, only two countries get involved into this definition, called bilateral rate. Therefore, real exchange rate can be expressed as "the ratio of the price level in the home country to the price level in the foreign country" (Ellis, 2002,p1).
However, in the real world, usually there are more than two countries in the global businesses. Accordingly, there are more than two currencies that should be used to define the real exchange rate, called multilateral rate. On the basis of weight average of these different currencies, real exchange rate can be calculated (Ellis, 2002).
In terms of weighted average of multilateral rate, there are two averaging process to calculate real exchange rate. According to the research of Ellis (2002), arithmetic average is a simple approach, but more familiar. Comparatively, geometric average is preferable theoretically and statistically. However, it can be complicate to calculate in a particular short period. Therefore, there are alternative ways to combine these two processes to calculate average real exchange rate.
According to the definition, the real exchange rate is a relative price, which always floats because of changeable nominal exchange rate and price level (Gylfason, 2002).