The real exchange rate (RER) compares the relative price of two countries’ consumption baskets. You may be interested in getting more information than the relative price of two currencies, or the nominal exchange rate. For example, you may want to know what one dollar can buy in the Euro-zone countries or what one euro can buy in the United States. In this case, you’re interested in the (RER).
Therefore, to calculate the RER, you need to know two things: the nominal exchange rate and the price of the two countries’ consumption baskets.
A country’s consumption basket tells you what the average consumer buys, and its price indicates how much consumers pay for it. For example, in the U.S., the Consumer Price Index (CPI) is calculated based on a consumption basket consisting of about 80,000 goods and services.
Each country’s consumption basket is expressed in its domestic currency. If you know the nominal exchange rate and the prices of two countries’ consumption baskets, you can express the price of one country’s consumption basket in the other country’s currency. This information enables you to calculate the RER. In other words, you can compare the prices of two countries’ consumption baskets in the same currency.
Suppose you know the dollar–euro nominal exchange rate, the euro price of the European consumption basket, and the dollar price of the U.S. consumption basket. You can’t divide the price of the European consumption basket by that of the U.S. consumption basket because the prices of these consumption baskets are denominated in different currencies. Therefore, follow this concept:
RER = (Nominal exchange rate x Price of the foreign basket) / (Price of the domestic basket)