What is equilibrium real exchange rate?

Abstract. An equilibrium exchange rate is here defined as the level that is consistent with simultaneous internal and external balances as specified in Montiel (1996).

What is the equilibrium exchange rate determined by?

Graphically, intersection of demand and supply curves determines the equilibrium exchange rate of foreign currency. At any particular time, the rate of foreign exchange must be such at which quantity demanded of foreign currency is equal to quantity supplied of that currency.

What happens when the real exchange rate rises?

If a countries real exchange rate is rising, it means its goods are becoming more expensive relative to its competitors. An increase in the real exchange rate means people in a country can get more foreign goods for an equivalent amount of domestic goods.

What are the advantages of a floating exchange rate?

The main economic advantages of floating exchange rates are that they leave the monetary and fiscal authorities free to pursue internal goals—such as full employment, stable growth, and price stability—and exchange rate adjustment often works as an automatic stabilizer to promote those goals.

What happens when real exchange rate appreciates?

A real appreciation is an increase in the real exchange rate. With real appreciation the same quantity of domestic goods can be traded for more foreign goods. A real depreciation is a drop in the real exchange rate.

What causes the real exchange rate to decrease?

If the price of a country’s exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. If the price of exports rises by a smaller rate than that of its imports, the currency’s value will decrease in relation to its trading partners.

Why is equilibrium level of exchange rates important?

Assessing the equilibrium levels of exchange rates is an important responsibility of macroeconomic policymakers. Exchange rates have a major influence on the prices faced by consumers and producers throughout the world, and the consequences of substantial misalignments can be extremely costly.

What is the equation for real exchange rates?

The core equation is RER= eP*/P, where, in our example, e is the nominal dollar-euro exchange rate, P* is the average price of a good in the euro area, and P is the average price of the good in the United States. In the Big Mac example, e = 1.36.

Why do we focus on real exchange rates?

The focus on real exchange rates is consistent with perceptions that it is generally appealing—both conceptually and empirically—to model economic behavior in terms of relative price levels rather than absolute price levels.

When is a country’s REER is in equilibrium?

Being an average, a country’s REER may be in “equilibrium” (display no overall misalignment) when its currency is overvalued relative to that of one or more trading partners so long as it is undervalued relative to others.