Measuring the Real Exchange Rate: Pitfalls and Practicalities

The real exchange rate is an important concept in economic theory, but it is not directly observable and must be constructed, usually as an index. The construction of such indices requires a number of decisions – which currencies to include, the appropriate weighting scheme and the price measures to use – which materially alter the results. Unfortunately, theory often gives very little guidance on the appropriate assumptions to make when constructing an exchange rate index. This paper discusses the various choices, highlighting their differing implications. Some of the practical issues of calculation are also reviewed. Several exchange rate indices that have been used in analytical work in the Reserve Bank are presented. These will be updated quarterly on the Reserve Bank website at <http://www.rba.gov.au/statistics/>.