Calculation of Real Exchange Rate

CFA Level I
#1

Hi

I am confused about the calculation formula of the real exchange rate.

It is stated that the formula is

Real exchange rate (d/f) = nominal exchange rate (d/f) x (CPIforeign / CPIdomestic)

I learned that d/f means cost of a foreign currency unit in terms of domestic currency units.

Here is an example taken from SN Book2 pg231

[question removed by admin]

The answer given is $1.60/ x 112/110 = $1.629/

In this case U.K GBP is the base currency and USD is the price currency. So CPIdomestic will be UK’s CPI. My question is why not $1.60/ x 110/112 based on the formula?

Thanks for explaining in advance! :slight_smile:

#2

Recall that:

USDreal = USDnom / CPI-USD

and

GBPreal = GBPnom / CPI-GBP

Thus, the real exchange rate (USDreal / GBPreal) relates to the nominal exchange rate (USDnom / GBPnom) by:

USDreal / GBPreal = (USDnom / CPI-USD) / (GBPnom / CPI-GBP)

= (USDnom / CPI-USD) × (CPI-GBP / GBPnom)

= (USDnom / GBPnom) × (CPI-GBP / CPI-USD)

1 Like
#3

Thanks! Much clearer now.

In that case, this formula stated in the notes does not hold?

Real exchange rate (d/f) = nominal exchange rate (d/f) x (CPIforeign / CPIdomestic)

#4

This formula is correct.

Look at the last bit I posted:

With USD the domestic currency and GBP the foreign currency, this is exactly your formula.