<p>Both answers here are giving really good definitions of the concepts, but I think it's important to additionally talk about the relation between the two to clarify the justified confusion and to compare them.</p>

<p><strong>tl;dr</strong> RER is combining PPP theory with the current exchange rate to produce a rate that is taking purchase power into account. Read the two last paragraph to understand the confusion.</p>

<p>From <a href="https://en.wikipedia.org/wiki/Purchasing_power_parity" rel="nofollow noreferrer">Wikipedia</a>:</p>

<blockquote>
  <p>Purchasing Power Parity (PPP) is a theory that measures prices at different locations using a common basket of goods.</p>
</blockquote>

<p><strong>PPP</strong> is giving us a ratio (rate) that is fair in purchase power between different locations (according to the basket of goods).</p>

<p>The market exchange rates are not following PPP. This is why the <strong>RER</strong> exists. We apply PPP theory to the current exchange rates to get a "real" rate that takes purchase power into account. In other words, <strong>RER is using PPP</strong>.</p>

<p>From <a href="https://en.wikipedia.org/wiki/Exchange_rate#Purchasing_power_of_currency" rel="nofollow noreferrer">Wikipedia</a>:</p>

<blockquote>
  <p>The real exchange rate (RER) is the purchasing power of a currency relative to another at current exchange rates and prices</p>
</blockquote>

<p>This is confusing because, at least in online litterature, we don't seem to be explicitly mentioning their relation. For example, when we talk and teach about PPP, we often associate it with simple price indices to give usage examples (e.g. the <a href="https://en.wikipedia.org/wiki/Purchasing_power_parity#Big_Mac_Index" rel="nofollow noreferrer">Big Mac Index</a>). These indices are using the current exchange rate to compare between countries, so they are simply RERs normalized to one currency and using a specific good basket for the comparison (in this case one single item, the Big Mac). Since this is not mentionned and one leads to the other, the distinction often becomes unclear.</p>

<p>Another confusion factor is that you can easily find PPP rates, exchange rates and price indices online, but not RERs.</p>

CC BY-SA 4.0
2019-09-20T13:21:02.030Z
Thanks. I think I finally got it. Great answer! :)
Diego Jancic
CC BY-SA 4.0
2019-09-20T15:36:23.020Z
I don’t think it’s helpful to try make.your case by quoting extensively from a deeply confused (and thus misleading) Wikipedia article. If anything, it serves as a vivid reminder of why many schools and universities have banned Wikipedia from a list of acceptable sources from which to draw arguments.
Mico
CC BY-SA 4.0
2019-09-20T16:11:07.953Z
I think it is indeed helpful, since the answers here are having the exact same confused nature. The problem doesn't come from Wikipedia alone. I wasn't able to correctly identify how the concepts were related to each other reading the other answers. Note that I only quoted definitions, and they are perfectly valid.
Simon
CC BY-SA 4.0
2019-09-20T21:43:56.767Z
@Simon - The sentences you excerpted from Wikipedia -- "Purchasing Power Parity (PPP) is a theory that measures prices at different locations using a common basket of goods" and "The real exchange rate (RER) is the purchasing power of a currency relative to another at current exchange rates and prices" are both factually wrong  E.g., PPP does not, and never has, "measure[d] prices at different locations using a common basket of goods." Whoever wrote this has done readers -- including you -- a huge disservice. Your claim that the "quoted definitions" are "perfectly valid" does not pass muster.
Mico
CC BY-SA 4.0
2019-09-20T03:05:32.327Z
2019-09-20T04:21:01.463Z
2019-09-20T04:21:01.463Z
Simon
<p>Effectively RER is calculated by converting currency from Country A to country B first, than purchasing the same goods in Country B, whereas PPP is the ratio of the price of goods in each country. </p>

<p>From the <a href="http://en.wikipedia.org/wiki/Exchange_rate#Purchasing_power_of_currency" rel="nofollow noreferrer">Wikipedia article</a>:</p>

<blockquote>
  <p>If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and GDP deflators (price levels) of the two countries, and the real exchange rate would always equal 1</p>
</blockquote>

<p>Unfortunately, barriers to trade (as well as potential Ricardian advantages in production) often mean one good is "cheaper" in a given country than another, so RER and PPP can and do differ.</p>

<p><strong>Edit:</strong> As <a href="https://economics.stackexchange.com/users/25/mico">Mico</a> pointed out in the comments, $PPP = RER$ is only true if all goods are freely tradable, fungible, <strong>and</strong> there are no capital flows between the two countries. </p>

CC BY-SA 3.0
2014-11-18T23:31:16.673Z
The claim made in the Wikipedia article you cite -- about market exchange rates having to be equal to PPP exchange rates if all goods were freely tradable and if residents of various economies consumed identical baskets -- is correct only if there are *no capital flows*. With free international capital mobility, the two types of exchange rates can easily diverge for prolonged periods of time even if there are no barriers to trade and transportation costs in international trade are negligible.
Mico
CC BY-SA 3.0
2014-11-19T02:52:11.747Z
Agreed. Will update.
Jason Nichols
CC BY-SA 3.0
2014-11-18T22:04:49.697Z
2014-11-19T05:14:12.427Z
2017-04-13T12:51:38.253Z
Jason Nichols
<p>There are several exchange rate concepts that need to be distinguished. There are bilateral and multilateral (aka "effective") exchange rates, nominal and real exchange rates, and market-price versus PPP (purchasing power parity) exchange rates.</p>

<ul>
<li><p>Let's start with the simplest concept: A bilateral <em>nominal</em> exchange rate, e.g., 117 yen/(US dollar), 0.8 pounds/euro, 7.7 (Swedish krona)/(Swiss Franc), etc. These are the exchange rates that are commonly reported in newspapers and in any number of online outlets. </p>

<ul>
<li>Aside: There are two distinct quoting conventions for exchange rates: the "E" system (with the home currency in the numerator) and the inverse, the "R" system. A nominal exchange of 1.2 Swiss francs per euro is expressed in the "R" system from the point of view of a euro area resident, and in the "E" system from the point of view of a resident of Switzerland. The "R" convention is conceptually easier to work with, since an <em>increase</em> of the numbers of foreign currency units per unit of home currency corresponds naturally to an <em>appreciation</em> of the home currency. Using the "E" system, the opposite is the case. There seems to be little or no standardization with regard to quoting conventions of bilateral exchange rates. However, multilateral exchange rates are always expressed using the "R" convention, such that a larger numerical value corresponds to an appreciation of the currency, and vice versa.</li>
</ul></li>
<li><p>A bilateral <em>real</em> exchange rate is the bilateral nominal exchange rate multiplied by a ratio of price indices of the two currencies. (How the ratio is taken depends on whether the currency pair is quoted in the E or R method.) Naturally, many different price indices can be used; most common, though, is the use of headline CPIs (consumer price indices). Because CPI series are generally monthly (or even lower frequency) time series, real exchange rates too are generally monthly time series. The home currency appreciates in real terms against a foreign currency either if the home currency appreciates in nominal terms or if the home country's inflation rate is lower than that in the foreign currency.</p></li>
<li><p>While bilateral exchange rates are straightforward to report, interest often centers on multilateral exchange rates. The home economy has trade and financial ties not just with one other economy but (usually) with many different economies. To form an index of the multilateral exchange value of the home currency, it's necessary to weight the various bilateral exchange rates according to the importance of the foreign economies. Again, many different weighting schemes are possible; a common scheme uses merchandies trade weights based on imports and/or exports between the home economy and the most important foreign economies. Because bilateral exchange rates are ratios of relative prices, an exchange rate index (aka a multilateral or efffective exchange rate) is computed as a Tornqvist index (a geometric rather than arithmetic average).</p></li>
<li><p>Up to now, we've mainly dealt with market prices for both nominal and real exchange rates. While that's perfectly OK for many applications, it's not the most helpful way to proceed if one wants to make comparisons of standards of living across countries. Purchasing power parity (PPP) tries to facilitate such comparisons by figuring how much a <em>standard</em> "basket of goods" -- frequently, but not always, the goods in the CPI baskets -- costs in various countries. </p>

<p>A famous case of a bilateral PPP exchange rate is the "Big Mac Index" of <em>The Economist</em> magazine: Since a Big Mac is pretty much the same in all countries where it's sold, one can work out the PPP-based bilateral exchange between the U.S. dollar (say) and all other countries as the exchange rates that would make the cost of purchasing a Big Mac the same. (Obviously, <em>The Economist</em> makes no claim that the Big Mac features prominently in anybody's consumption basket.) </p>

<p>By comparing nominal and PPP-based exchange rates it is possible to make statements such as "currency A is overvalued (or undervalued) against currency B". Of course, different choices of consumption baskets will lead to different PPP exchange rates. Hence, depending on the choice of basket, conflicting answers may arise as to whether a currency is over- or undervalued.</p></li>
</ul>

<p>For more about the Big Mac index, check out the <a href="http://www.economist.com/content/big-mac-index">Economist Magazine's own website</a>.</p>

<p>For a non-technical discussion of the dollar indices used by the staff of the U.S. Federal Reserve Board see, e.g, the 2005 article <a href="http://www.federalreserve.gov/pubs/bulletin/2005/winter05_index.pdf">Indexes of the Foreign Exchange Value of the Dollar</a> in Federal Reserve Bulletin.</p>

CC BY-SA 3.0
2014-11-18T23:22:36.143Z
2014-11-18T23:22:36.143Z
Mico
<p>I'm having troubles to understand the difference between the Real Exchange Rate and the PPP rate.</p>

<p>I know the first one is calculated using a basket of goods and services so that the non-tradeable basket costs the same in 2 countries (imagining a 2-country world).  Now, isn't that the rate that would hold if PPP applies?</p>

<p>I think I'm wrong if I say that the real exchange rate is the one that makes PPP become valid.  Any help appreciated.</p>

<currency><purchasing-power-partity><exchange-rates>
Real Exchange Rate vs PPP rate
Diego Jancic
# Real Exchange Rate vs PPP rate

(Asked by: username_0 on 2014-11-18)

I'm having troubles to understand the difference between the Real Exchange Rate and the PPP rate.

I know the first one is calculated using a basket of goods and services so that the non-tradeable basket costs the same in 2 countries (imagining a 2-country world). Now, isn't that the rate that would hold if PPP applies?

I think I'm wrong if I say that the real exchange rate is the one that makes PPP become valid. Any help appreciated.

**Tags:** currency, purchasing-power-partity, exchange-rates


---

## 3 answers

### Answer by username_1 on 2019-09-20. Score: 1 | Accepted answer

Both answers here are giving really good definitions of the concepts, but I think it's important to additionally talk about the relation between the two to clarify the justified confusion and to compare them.

**tl;dr** RER is combining PPP theory with the current exchange rate to produce a rate that is taking purchase power into account. Read the two last paragraph to understand the confusion.

From [Wikipedia](https://en.wikipedia.org/wiki/Purchasing_power_parity):

> Purchasing Power Parity (PPP) is a theory that measures prices at different locations using a common basket of goods.

**PPP** is giving us a ratio (rate) that is fair in purchase power between different locations (according to the basket of goods).

The market exchange rates are not following PPP. This is why the **RER** exists. We apply PPP theory to the current exchange rates to get a "real" rate that takes purchase power into account. In other words, **RER is using PPP**.

From [Wikipedia](https://en.wikipedia.org/wiki/Exchange_rate#Purchasing_power_of_currency):

> The real exchange rate (RER) is the purchasing power of a currency relative to another at current exchange rates and prices

This is confusing because, at least in online litterature, we don't seem to be explicitly mentioning their relation. For example, when we talk and teach about PPP, we often associate it with simple price indices to give usage examples (e.g. the [Big Mac Index](https://en.wikipedia.org/wiki/Purchasing_power_parity#Big_Mac_Index)). These indices are using the current exchange rate to compare between countries, so they are simply RERs normalized to one currency and using a specific good basket for the comparison (in this case one single item, the Big Mac). Since this is not mentionned and one leads to the other, the distinction often becomes unclear.

Another confusion factor is that you can easily find PPP rates, exchange rates and price indices online, but not RERs.

> **Comments:**
> **username_0**: Thanks. I think I finally got it. Great answer! :)  
> **username_2**: I don’t think it’s helpful to try make.your case by quoting extensively from a deeply confused (and thus misleading) Wikipedia article. If anything, it serves as a vivid reminder of why many schools and universities have banned Wikipedia from a list of acceptable sources from which to draw arguments.  
> **username_1**: I think it is indeed helpful, since the answers here are having the exact same confused nature. The problem doesn't come from Wikipedia alone. I wasn't able to correctly identify how the concepts were related to each other reading the other answers. Note that I only quoted definitions, and they are perfectly valid.  
> **username_2**: @username_1 - The sentences you excerpted from Wikipedia -- "Purchasing Power Parity (PPP) is a theory that measures prices at different locations using a common basket of goods" and "The real exchange rate (RER) is the purchasing power of a currency relative to another at current exchange rates and prices" are both factually wrong  E.g., PPP does not, and never has, "measure[d] prices at different locations using a common basket of goods." Whoever wrote this has done readers -- including you -- a huge disservice. Your claim that the "quoted definitions" are "perfectly valid" does not pass muster.  

---

### Answer by username_2 on 2014-11-18. Score: 14

There are several exchange rate concepts that need to be distinguished. There are bilateral and multilateral (aka "effective") exchange rates, nominal and real exchange rates, and market-price versus PPP (purchasing power parity) exchange rates.

* Let's start with the simplest concept: A bilateral *nominal* exchange rate, e.g., 117 yen/(US dollar), 0.8 pounds/euro, 7.7 (Swedish krona)/(Swiss Franc), etc. These are the exchange rates that are commonly reported in newspapers and in any number of online outlets.

  + Aside: There are two distinct quoting conventions for exchange rates: the "E" system (with the home currency in the numerator) and the inverse, the "R" system. A nominal exchange of 1.2 Swiss francs per euro is expressed in the "R" system from the point of view of a euro area resident, and in the "E" system from the point of view of a resident of Switzerland. The "R" convention is conceptually easier to work with, since an *increase* of the numbers of foreign currency units per unit of home currency corresponds naturally to an *appreciation* of the home currency. Using the "E" system, the opposite is the case. There seems to be little or no standardization with regard to quoting conventions of bilateral exchange rates. However, multilateral exchange rates are always expressed using the "R" convention, such that a larger numerical value corresponds to an appreciation of the currency, and vice versa.
* A bilateral *real* exchange rate is the bilateral nominal exchange rate multiplied by a ratio of price indices of the two currencies. (How the ratio is taken depends on whether the currency pair is quoted in the E or R method.) Naturally, many different price indices can be used; most common, though, is the use of headline CPIs (consumer price indices). Because CPI series are generally monthly (or even lower frequency) time series, real exchange rates too are generally monthly time series. The home currency appreciates in real terms against a foreign currency either if the home currency appreciates in nominal terms or if the home country's inflation rate is lower than that in the foreign currency.
* While bilateral exchange rates are straightforward to report, interest often centers on multilateral exchange rates. The home economy has trade and financial ties not just with one other economy but (usually) with many different economies. To form an index of the multilateral exchange value of the home currency, it's necessary to weight the various bilateral exchange rates according to the importance of the foreign economies. Again, many different weighting schemes are possible; a common scheme uses merchandies trade weights based on imports and/or exports between the home economy and the most important foreign economies. Because bilateral exchange rates are ratios of relative prices, an exchange rate index (aka a multilateral or efffective exchange rate) is computed as a Tornqvist index (a geometric rather than arithmetic average).
* Up to now, we've mainly dealt with market prices for both nominal and real exchange rates. While that's perfectly OK for many applications, it's not the most helpful way to proceed if one wants to make comparisons of standards of living across countries. Purchasing power parity (PPP) tries to facilitate such comparisons by figuring how much a *standard* "basket of goods" -- frequently, but not always, the goods in the CPI baskets -- costs in various countries.

  A famous case of a bilateral PPP exchange rate is the "Big Mac Index" of *The Economist* magazine: Since a Big Mac is pretty much the same in all countries where it's sold, one can work out the PPP-based bilateral exchange between the U.S. dollar (say) and all other countries as the exchange rates that would make the cost of purchasing a Big Mac the same. (Obviously, *The Economist* makes no claim that the Big Mac features prominently in anybody's consumption basket.)

  By comparing nominal and PPP-based exchange rates it is possible to make statements such as "currency A is overvalued (or undervalued) against currency B". Of course, different choices of consumption baskets will lead to different PPP exchange rates. Hence, depending on the choice of basket, conflicting answers may arise as to whether a currency is over- or undervalued.

For more about the Big Mac index, check out the [Economist Magazine's own website](http://www.economist.com/content/big-mac-index).

For a non-technical discussion of the dollar indices used by the staff of the U.S. Federal Reserve Board see, e.g, the 2005 article [Indexes of the Foreign Exchange Value of the Dollar](http://www.federalreserve.gov/pubs/bulletin/2005/winter05_index.pdf) in Federal Reserve Bulletin.


---

### Answer by username_3 on 2014-11-18. Score: 8

Effectively RER is calculated by converting currency from Country A to country B first, than purchasing the same goods in Country B, whereas PPP is the ratio of the price of goods in each country.

From the [Wikipedia article](http://en.wikipedia.org/wiki/Exchange_rate#Purchasing_power_of_currency):

> If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and GDP deflators (price levels) of the two countries, and the real exchange rate would always equal 1

Unfortunately, barriers to trade (as well as potential Ricardian advantages in production) often mean one good is "cheaper" in a given country than another, so RER and PPP can and do differ.

**Edit:** As [username_2](https://economics.stackexchange.com/users/25/username_2) pointed out in the comments, $PPP = RER$ is only true if all goods are freely tradable, fungible, **and** there are no capital flows between the two countries.

> **Comments:**
> **username_2**: The claim made in the Wikipedia article you cite -- about market exchange rates having to be equal to PPP exchange rates if all goods were freely tradable and if residents of various economies consumed identical baskets -- is correct only if there are *no capital flows*. With free international capital mobility, the two types of exchange rates can easily diverge for prolonged periods of time even if there are no barriers to trade and transportation costs in international trade are negligible.  
> **username_3**: Agreed. Will update.  

---

