Real exchange rate

Indian Economy glossary

Topic: Balance of Payments and Exchange Rates · NCERT: Class 12, Ch 6 "Open Economy Macroeconomics"

Meaning

The real exchange rate (R) is the price of foreign goods measured in domestic goods. It tells us how many units of Indian goods we must give up to buy one unit of foreign goods.

Formula: R = eP* / P

  • e = nominal exchange rate (rupees needed to buy one unit of foreign currency, for example ₹85 per $1)
  • P* = foreign price level
  • P = Indian price level

It matters because buyers compare the actual prices of goods, not just currency prices. So R, not the ₹/$ rate alone, decides whether Indian goods are cheap or costly for the world. That makes it the true measure of a country's price competitiveness in trade.

Explanation

How it works: nominal rate adjusted for prices

  • The nominal exchange rate (e) is the rate you see at a bank. It shows only the price of a currency.
  • R also brings in price levels at home and abroad. It asks: after converting currencies, which goods are actually cheaper?
  • Worked example (NCERT Q4, yen):
  • 1.25 yen buys ₹1, so ₹0.8 buys 1 yen (1 / 1.25 = 0.8). So e = 0.8.
  • Japanese price level P* = 3. Indian price level P = 1.2.
  • R = 0.8 × 3 / 1.2 = 2.
  • Meaning: one unit of Japanese goods costs as much as two units of Indian goods. Japanese goods are relatively dear, and this helps Indian exports.

What a rise or fall in R does

  • R rises = real depreciation
  • Foreign goods become dearer compared with Indian goods.
  • Indians buy fewer imports, and foreigners buy more Indian exports.

  • The trade balance (exports minus imports) improves.

  • R falls = real appreciation

  • Indian goods become dearer abroad.
  • Exports fall and imports rise.
  • The trade balance worsens.

What makes R move

R changes when any of its three parts changes:

  • e rises (the rupee depreciates in nominal terms), so R rises.
  • P* rises (foreign inflation), so R rises.
  • P rises (Indian inflation), so R falls.
  • Key point (NCERT Q3): suppose the rupee depreciates 5% but Indian prices also rise 5%. Then R does not change, and India gains no competitiveness.
  • Fixed rate with higher home inflation (NCERT Q16):
  • e is fixed, as under Bretton Woods (the post-war system of fixed exchange rates) or a peg (a currency tied to another at a fixed rate).
  • Indian prices rise faster than foreign prices, so R falls. This is a real appreciation, even though e has not moved.
  • Example: e = 50, P* = 100, and P rises from 100 to 110.
  • R falls from 50 × 100/100 = 50 to 50 × 100/110 ≈ 45.5. That is a real appreciation of about 9%.

Link with PPP

  • Purchasing power parity (PPP) is the idea that, in the long run, exchange rates move until the same good costs the same everywhere. Under PPP, e = P / P*.
  • Put this into the formula and you get R = 1 when PPP holds exactly.
  • When R moves away from 1, the exchange rate has moved away from PPP.

Effective version: REER

  • A bilateral rate compares the rupee with only one currency (such as ₹/$), so it can mislead. The rupee can rise against the dollar and fall against the euro at the same time.
  • NEER (nominal effective exchange rate): a trade-weighted average of the rupee's rates against a basket of partner currencies. A partner that trades more with India gets a bigger weight.
  • REER (real effective exchange rate): the NEER adjusted for relative inflation. It is the real exchange rate measured against many partners at once.
  • Worked example (made-up numbers):
  • NEER index = 95, Indian CPI index = 130, weighted partner CPI index = 110.
  • REER = 95 × (130 / 110) ≈ 112.
  • The rupee has fallen in nominal terms. But Indian inflation was higher, so in real terms the rupee is overvalued by about 12%.

In India

  • The RBI measures it. It publishes NEER and REER indices for a 40-currency basket with base 2015-16 = 100 [2].
  • 2021 revision:
  • The base year moved from 2004-05 to 2015-16 [2].
  • The basket grew from 36 to 40 currencies. It now covers 88% of India's total trade, up from 84% [2].
  • Weights change over time. Each partner's weight is based on its trade with India (exports plus imports) over the preceding three years [2].
  • The REER is CPI-based, so it uses consumer price inflation to adjust for prices [2].

  • The new REER stayed close to 100 for most of 2004-05 to 2019-20 [2].

  • Reading RBI's index: a rise in the index means the rupee appreciates. A REER above 100 means overvaluation compared with the base year, so exports lose price competitiveness. A REER below 100 means undervaluation.

  • Policy use: under today's managed float (the market sets the rate, but the RBI steps in at times), the RBI watches the REER. It does not target any fixed level of the rupee. It intervenes only to smooth excess volatility (sharp ups and downs).
  • 1991 lesson:
  • The rupee was pegged and administered. For years, India's inflation stayed above its partners' inflation.
  • So the rupee became overvalued in real terms. This widened the trade deficit behind the 1991 BoP crisis (balance of payments crisis, when India nearly ran out of foreign currency to pay for imports).
  • The rupee was devalued in July 1991 to restore competitiveness. Market-determined rates followed in 1993.

Don't confuse with

  • Nominal exchange rate (e): this is only the price of one currency in another. R also adjusts for price levels. e can stay fixed while R changes.
  • REER vs R: R compares India with one country. REER compares India with a trade-weighted basket of 40 currencies [2]. Also, the direction is opposite: in RBI's REER, a rise means appreciation, but in R = eP*/P, a rise means depreciation.
  • Terms of trade (ToT): ToT is the ratio of export prices to import prices, (Px/Pm) × 100. It measures how many imports one unit of exports can buy. R measures the price of all foreign goods compared with domestic goods.
  • PPP exchange rate: this is the rate at which R = 1, a long-run benchmark. The real exchange rate shows how far the actual rate has moved from that benchmark.

Prelims Hooks

  • R = eP*/P. A rise in R is a real depreciation. It makes imports dearer and exports cheaper, so the trade balance improves.
  • Trap: under a fixed nominal rate, higher home inflation causes a real appreciation, not a depreciation.
  • If the rupee depreciates 5% and Indian prices rise 5%, R stays the same, so there is no gain in competitiveness.
  • When PPP holds exactly, R = 1.
  • REER = NEER adjusted for relative inflation. In RBI's series, a REER above 100 signals overvaluation.
  • The RBI's 40-currency REER uses base 2015-16 = 100, is CPI-based, and covers 88% of India's trade (revised in 2021) [2].

Mains Points

  • Weak rupee vs strong rupee debate:
  • Export competitiveness depends on the REER, not the ₹/$ rate.
  • If the rupee falls only as much as the inflation gap, there is no real gain.

  • So policy should focus on low inflation and higher productivity, not on pushing the rupee down.

  • 1991 and silent real appreciation:

  • Under a peg, a persistent inflation gap slowly raises the real value of the currency.
  • This widens the trade deficit and drains forex reserves, as happened before 1991.

  • The managed float with REER monitoring by the RBI is the institutional answer to that lesson.

  • Capital inflows and Dutch disease risk:

  • Large inflows of foreign money can push the REER above 100. This hurts manufacturing and other tradables (goods that can be sold abroad).
  • This is one reason the RBI buys foreign currency and builds forex reserves during inflow surges (sterilised intervention).
  • This links REER management to GS-III themes of export growth and industrial policy.

Related concepts

Read more

Sources

  1. 1Class 12, Ch 6 "Open Economy Macroeconomics" (primary)
  2. 2RBI Bulletin (January 2021), "Revision of NEER and REER Indices"rbi.org.in · tier 1