But it actually reflects the real economic phenomenon, so it is important to analyze how real exchange rate moves and how to measure its movement.
Measurement of Real Exchange rate.
As mentioned above, it is a complicate process to calculate the real exchange rate due to the movements of different bilateral rates. Consequently, there are so many elements that have to be considered, such as bilateral rates components, weights average movements, price level, etc. Mainly on the basis of the research by Ellis (2002), this section examines different measurements to construct different real exchange rate indexes. .
Firstly, due to the existence of uncertainty in the international business situation, it is common that traded weight of a country moves at times. Therefore, adjustment on the real exchange rate is needed. For example, if one of the trading partners increases its import shares to home country, the real exchange rate should be updated to reflect the new trade patterns. Moreover, when dealing with changing weights index, it has to be noted that splicing adjustment should be applied (Ellis, 2002).
Secondly, as real exchange rate is calculated on the basis of different bilateral exchange rates, the components of bilateral exchange rates should be considered. In an ideal situation, all the significant currencies could be chosen into the weight index. However, if a specific single currency moves dramatically, it could influence the overall exchange rate in a wrong direction. Therefore, in such particular case, this extreme single currency would be excluded from the components of bilateral rates (Ellis, 2002).
The choice of price is another important issue when calculating real exchange rate indices. Basically, consumer price index (CPI) is the most popular type of price index because it is easy to compare across countries. Sometimes it could be preferable to use producer prices or costs to reflect competitive movements, if those data are available.
