REAL EXCHANGE RATES

Theoretically, there are two principal definitions of real exchange rate:

· In external terms, defined as the nominal exchange rate adjusted for price level differences between countries, i.e. as the ratio of the aggregate foreign price (or cost)  level to home country’s aggregate price (or cost) level measured in a common currency.

· In internal terms, as the ratio of the domestic price of tradable to non-tradable goods within a single country.

The concept of external real exchange rate is derived from the purchasing power parity (PPP) theory that compares two countries and the relative prices of baskets of goods produced (or consumed). The internal real exchange rate is an indication of domestic resource allocation incentives in the home country. Within these two broad real exchange rate concepts we can have several alternative formulations or measures under different analytical frameworks

Source: Maxwell Opoku-Afari Resarch paper .