The Real Exchange Rate

The real exchange rate can and does vary substantially over time. Argentina in the 1990s provides a nice illustration of real exchange rates in action. [4] Argentina had acurrency board during this period. Under a currency board, a country maintains a fixed exchange rate by backing its currency completely with another currency. Although Argentina did have its own currency (the Argentine peso), each peso in circulation was backed by a US dollar held by the Argentine central bank. You could at any time exchange pesos for dollars at a nominal exchange rate of 1. shows what happened to prices in Argentina and the United States over this period. Look at 1992–95. Both countries had some inflation. But prices were increasing faster in Argentina than in the United States. The real exchange rate (Argentina–United States) is given by real exchange rate = ( Argentine price level US price level ) × price of the peso in dollars = ( Argentine price level US price level ) because the price of the peso in dollars was 1. Therefore the real exchange rate appreciated as Argentine inflation outpaced US inflation. The appreciation of the real exchange rate meant that Argentine goods became more expensive in other countries, so Argentine exports became less competitive. (The problem was compounded by the fact that the US dollar [and hence the peso] also appreciated against the currencies of neighboring countries such as Brazil.) Without the currency board, it would have been possible for the nominal exchange rate (price of the peso in dollars) to decline, offsetting the effects of the inflation rate. Instead, this appreciation of the real exchange rate ended up causing substantial economic problems in Argentina in the 1990s. In the second half of the decade, the real exchange rate began to depreciate because the inflation rate in Argentina was lower than in the United States. The appreciation at the start of the decade had been so large, however, that the real exchange rate in 1999 was still higher than it had been in 1992.