RDP 2001-04: Measuring the Real Exchange Rate: Pitfalls and Practicalities 1. Introduction

The real exchange rate is an important concept in international macroeconomics, used in most textbook models (for example, Turnovsky (1997)). It is usually defined as the product of the nominal exchange rate, expressed as the number of foreign currency units per home currency unit, and the relative price level, expressed as the ratio of the price level in the home country to the price level in the foreign country. There are only two countries in this definition; the exchange rate used is a bilateral rate.

However, in the real world, there are more than two currencies. Therefore every country is affected by the movements of more than one bilateral exchange rate. To assess the net effect of movements in a number of bilateral (real) exchange rates, some sort of weighted average of them is needed.

This complication is analogous to the issues faced when measuring the price level; except in the one-good world of many theoretical economic models, measures of the price level must combine the prices of many goods. This boils down to a choice of components and their weights. For the price level, a common choice of components is those goods and services most commonly purchased by (some subset of) consumers, and the weights corresponding to their shares of those consumers' total expenditure. These choices are on occasion controversial, but they make little difference over the medium term (Australian Bureau of Statistics 1992).

For the exchange rate, however, the choices of which bilateral exchange rates to include and the appropriate weights to use are less clear-cut. In large part, the choice of index depends on the issue being investigated. For example, an index weighted by import shares might be most appropriate when investigating the effects of exchange rate movements on the domestic prices of imported goods. The effect of nominal exchange rate movements on a nation's foreign debt must be measured by an index weighted by the currencies' shares of foreign borrowings. There is no single ‘right’ measure of the exchange rate.

Selection of the best available exchange rate index is particularly important if bilateral rates are moving in opposite directions. In those circumstances, exchange rate indices constructed on different bases can give quite different results. An example of this was the divergent movements in 1997 and early 1998 of the exchange rates between the Australian dollar and the currencies of countries initially affected by the Asian crisis (Thailand, Indonesia and Korea), compared with the exchange rates between the Australian dollar and the currencies of major industrialised nations (RBA 1998).

In short, the translation from the real exchange rate of theory to real-world data is not straightforward; judgement is required when selecting or constructing an exchange rate measure for empirical research. This paper explains some of the issues faced in constructing both real and nominal exchange rate measures, and highlights the implications of choosing particular components or calculation methods. Although there are some approaches that are strictly preferable to others, there remain a large number of possible indices to choose from. The aim of this paper is to guide users in making choices that are appropriate to their needs, rather than to dictate one – or even a few – ‘right’ measure of the real exchange rate.

The paper is structured as follows. The next section explains the mechanics of calculating a real exchange rate index correctly. Section 3 discusses the advantages and disadvantages of different weighting schemes. Section 4 presents a set of alternative real exchange rate indices, and explores their differing implications for two econometric equations that have been used in a number of previous RBA studies. After a brief conclusion, the data sources and methodology are set out in the appendix. A selection of real exchange rate indices are now being published on the RBA website and will be updated quarterly.