Interpreting economic data: calculating the real exchange rate

Economists and financial commentators often refer to the exchange rate when theydiscuss the economic situation. However, for each currency there are as many exchangerates as there are other currencies and it is difficult to judge which if any should beconsidered the most important. In this article we will show how it is possible to take datafor individual exchange rates and construct an index which is economically meaningful.First we show how to average exchange rate data to construct a measure known as theeffective exchange rate. This allows us to judge whether on average the pound hasappreciated or depreciated relative to other world currencies. However, the effectiveexchange rate does not make allowances for differences in the price of goods betweendifferent countries. Therefore in the next section we show how we can make such anadjustment to obtain a measure known as the real effective exchange rate. In the finalsection this allows us to discuss the impact of the exchange rate on the level ofinternational competitiveness and hence on the overall economy. All data in this articleare taken from the IMF’s International Financial Statistics database.