Question

A real effective exchange rate index adjusts exchange rates to incorporate the effects of inflation in different countries.

True or False?

Answer 1

True

The real effective exchange rate tells us whether the prices of goods and services at home are higher or lower than their prices abroad. If the domestic prices are lower, then we could have healthy exports resulting in a trade surplus. On the other hand, If domestic prices are higher, then we could expect that higher imports and resulting trade deficit.

Just assume two currencies. If Euro is at 80 Indian rupees and 1 burger costs 1 Euro, ideally it should cost 80 rupees in india. But if it is not case, then real effective exchange rate will come into the picture to give a proper exchange rate levelling the prices in Europe and india. If the same burger costs 60 Indian rupees, the real effective exchange rate should be 1Euro=60 rupees.

So real effective exchange rate adjusts the inflation between the countries