Inflation and Exchange Rate Definition
Before we go into more detail about how inflation affects the real exchange rate, let's first review the definitions of inflation and exchange rates.
Inflation refers to the increase in the general price level of an economy.
The (nominal) exchange rate is the rate at which one currency trades for another currency.
This is the exchange rate that people usually talk about. It is the exchange rate that you see posted in the bank. It tells you how much foreign currency you will get by trading in your home currency and the other way around. Economists call this the nominal exchange rate. Then, there is also the real exchange rate. How does this differ from the nominal exchange rate?
The real exchange rate is the exchange rate adjusted for the aggregate price levels in different countries. It is the rate at which the goods and services of one country can trade for the goods and services of another country.
Does this still sound a bit abstract? Here's a trick. Usually, when economists add the word "real" in front of another term, that means that it's adjusted for inflation. The real exchange rate is the exchange rate adjusted for the price levels of the two countries.
Inflation and Exchange Rate formula
What is the formula for calculating the real exchange rate, and what does inflation have to do with it?
Let's take it one step at a time. First, here is the formula:
\(\hbox {Real exchange rate} = \hbox {Nominal exchange rate} \times \frac {\hbox {Domestic price}} {\hbox {Foreign price}}\)
Note how the nominal exchange rate is defined here:
\(\hbox {Nominal exchange rate} = \hbox{Foreign currency per domestic currency}\)
Let's do a small example to make sure that we get what this formula is saying.
Let's say that a burger costs $5 in the US, and the same burger costs 17.5 yuan in China. The nominal exchange rate between the US dollar and the Chinese yuan is 7 yuan per dollar. What is the real exchange rate, in this case, between the US and Chinese burgers?
Fig. 1 - Ready for some burgernomics?
That's where the nominal exchange rate comes in - we need to first convert the prices into the same currency. Let's convert the Chinese burger price into US dollars. We have the price of the Chinese burger at $2.5. In other words, the burger in China costs half the price as it does in the US. The real exchange rate is 2 Chinese burgers per US burger.
Or, if we use the formula to do all the steps:
\(\hbox{Real exchange rate} = \hbox {Nominal exchange rate} \times \frac {\hbox {Domestic price}} {\hbox {Foreign price}}=\)
\(=\frac {\hbox{(7 yuan/dollar)} \times \hbox{\$5/US burger}} {\hbox{17.5 yuan/Chinese burger}}= \)
\(=\hbox{2 Chinese burgers/US burger} \)
The real exchange rate tells us that a burger in the US costs twice as much as a burger in China.
But as economists, we are usually not just concerned with the relative price of one item but the comparison of the general price levels in different economies. To do this, we substitute the domestic price and foreign price in the earlier formula with the domestic and foreign price indexes.
\(\hbox{Real exchange rate} = \frac {\hbox{e} \times \hbox{P}} {\hbox{P*}} \)
Where:
\(\hbox{e}\) - the nominal exchange rate;
\(\hbox{P}\) - the domestic price index;
\(\hbox{P*}\) - the foreign price index.
The Big Mac Index
In the example before, we used the relative price of burgers in the US and China to illustrate a micro example of the real exchange rate. What if we take this exercise more seriously? Can it actually tell us something about what the exchange rate between different currencies should be? Maybe!
You see, thanks to the ubiquitous American fast food culture, McDonald's restaurants exist in almost every country of the world. All of these restaurants sell the Big Mac hamburger, which is pretty much the same good no matter which country the restaurant is in. This provides an interesting opportunity to compare the purchasing power of different currencies.
The Big Mac index was first published by The Economist in 1986 as a somewhat funny attempt at illustrating the concept of purchasing power parity. But it later picked up more serious interest and has become the subject of academic studies.
A word of caution, though: purchasing power parity (and the Big Mac index) are related but slightly different concepts from the real exchange rate. So don't try to replicate the calculation using that formula; otherwise, you will get really confused.
But here's an example of what insight the Big Mac index can offer.
In July 2022, a Big Mac costs €4.65 in the eurozone and $5.15 in the US.
Using The Economist's methodology, this suggests an exchange rate of 0.90 euros per US dollar. 1
Curious? Check out our explanation to learn more about Purchasing Power Parity.
Relationship between Inflation and Exchange Rate
What is the relationship between inflation and the exchange rate? What does inflation have to do with the nominal and real exchange rates? Well, the answer is: it depends.
The effects of inflation on the exchange rate
Inflation does not have direct effects on the nominal exchange rate, but the underlying cause of inflation might. Why is that? One cause of high inflation is an increase in the money supply. The nominal exchange rate is determined by the supply and demand of currencies in the foreign exchange market.
Let's say that the central bank in Mexico decides to increase the money supply to support the domestic economy while the central banks in other countries keep their money supply constant. There is now a higher supply of Mexican pesos in the foreign exchange market, while other factors remain the same. As a result, the Mexican peso depreciates in value against other currencies.
Inflation certainly affects the real exchange rate, but the real exchange rate also depends on whether and how the nominal exchange rate changes. All else equal, if the general price level is higher, goods and services become more expensive for foreigners. But if the increase in the general price level is coupled with a depreciation of the domestic currency in the same proportion, the real exchange stays the same as before. Let's do some calculations with an example to see this more clearly.
How to Calculate the Real Exchange Rate with Inflation?
How do we calculate the real exchange rate with information on inflation? We can simply plug in numbers in the real exchange rate formula:
\(\hbox {Real exchange rate} = \hbox {Nominal exchange rate} \times \frac {\hbox {Domestic price index}} {\hbox {Foreign price index}}\)
Where the nominal exchange rate is defined as:
\(\hbox {Nominal exchange rate} = \hbox{Foreign currency per domestic currency}\)
Calculating real exchange rate with inflation. Currency depreciation and inflation cancel each other out
Let's say that the Canadian dollar depreciates by 20% against the US dollar. The exchange rate goes from 1.1 Canadian dollars per US dollar to 1.32 Canadian dollars per US dollar. It's a depreciation of the Canadian dollar because you get more of it for the same amount of the US dollar.
Does this mean that things in Canada are cheaper than before for tourists from the US? The 20% depreciation is about the nominal exchange rate. We need to know about the real exchange rate because that is what actually matters. It turns out that during this time, Canada experiences some inflation, but the US does not. The general price level in Canada rises by 20%, with the price index rising from 100 to 120, while the US price index remains at 100. Where does this leave the real exchange rate?
\(\hbox {Real exchange rate} = \hbox {Nominal exchange rate} \times \frac {\hbox {Domestic price index}} {\hbox {Foreign price index}}\)
Real exchange rate before:
\(\hbox {Canadian dollars per US dollar} \times \frac {P_{US}} {P_{Can}} = 1.1 \times \frac {100} {100} = 1.1 \)
Real exchange rate after:
\(\hbox {Canadian dollars per US dollar} \times \frac {P_{US}} {P_{Can}} = 1.32 \times \frac {100} {120} = 1.1 \)
We see that the real exchange rate is the same. Things in Canada do not become cheaper for US tourists even if the Canadian dollar depreciates because the increase in inflation cancels it out.
Calculating real exchange rate with inflation. What about sticky prices?
The price of everything doesn't always adjust immediately in the face of inflation. Businesses may find it costly to increase their prices and decide to absorb some of the cost increases. This phenomenon is known as sticky prices. When a currency depreciates against other currencies, but the prices in that country don't increase as much, then things in that country have become cheaper for foreigners.
Learn more about that from our explanation: Sticky Prices.
Bulgarians and Greeks go cross-border shopping in Turkey
Turkey has faced a serious economic crisis. Its currency, the lira, has seen a big decline in value. At one point in late 2021, the Turkish lira lost 60% of its value against the US dollar since the beginning of the year (it also declined by similar proportions against other currencies).
Fig. 2 - The Turkish lira saw massive drops in value in 2021. Source: Investing.com
At the same time, the country saw massive inflation - the official figures had inflation numbers above 21%.2 While this situation was painful for the people who live in Turkey, it presented a bargain for the people who live across the border.
Notice that the inflation number is high, but the depreciation of the Turkish currency was an even larger proportion. As a result, things in Turkey became cheaper for everyone who didn't hold Turkish liras. It was not a surprise then that drones of people from neighboring Bulgaria and Greece took advantage of the situation and crossed the border for a weekend shopping in Turkey.2
Inflation and Real Exchange Rates - Key takeaways
- Inflation refers to the increase in the general price level.
- The (nominal) exchange rate is the rate at which one currency trades for another currency.
- The real exchange rate is the exchange rate adjusted for the aggregate price levels in different countries. It is the rate at which the goods and services of one country can trade for the goods and services of another country.
References
- The Economist. "The Big Mac index." https://www.economist.com/big-mac-index
- The Associated Press. "Bulgarian shoppers find bargains in Turkey as lira struggles." https://apnews.com/article/travel-business-lifestyle-bulgaria-prices-3fa76d0cd002daea5d776f78937c1214
- Fig. 2. The Turkish lira saw massive drops in value in 2021. Source: Investing.com. "TRY/USD - Turkish Lira US Dollar." https://www.investing.com/currencies/try-usd-historical-data
Frequently Asked Questions about Inflation and Real Exchange Rates
What is the relationship between inflation and exchange rate?
It depends. Inflation does not have a direct impact on the nominal exchange rate, but an increase in the money supply will make the currency depreciate. Inflation certainly affects the real exchange rate, but the real exchange rate also depends on whether and how the nominal exchange rate changes.
How do exchange rates influence inflation?
All else equal, if the home currency depreciates, foreign imports become more expensive. This is known as imported inflation.
Does inflation affect real exchange rate?
Yes, but the real exchange rate also depends on whether and how the nominal exchange rate changes.
How do you calculate real exchange rate with inflation?
Real exchange rate = Nominal exchange rate x (Domestic price index / Foreign price index)
What happens when exchange rate increases?
All else equal, when the foreign currency appreciates in value, foreign goods and services become more expensive.
