Research Discussion Paper – RDP 9309 Alternative Concepts of the Real Exchange Rate: A Reconciliation
July 1993
Abstract
Widespread reference to the real exchange rate stems from the belief that it is a useful summary indicator of key economic information. There exist, however, two forms of the real exchange rate: one form is based on deviations from purchasing power parity, while the other is based on the ratio of domestic prices of non-tradeables to tradeables. In this paper, an attempt is made to reconcile the two forms of the real exchange rate, both in theory and in practice. It is shown analytically that under certain restrictive conditions they will be equivalent. These conditions are, however, not always met so that in practice the two forms of the real exchange rate diverge. Changes in the productivity of the traded goods sector and the terms of trade are shown to be the principal sources of divergence. Identification of such economic fundamentals is central to the proper interpretation of movements in real exchange rates and, therefore, the efficacy of any attempt by policy makers to effect changes in them.