Q.Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and the price level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of Japanese goods in terms of Indian goods). (Hint: First find out the nominal exchange rate as a price of yen in rupees).

The Real Exchange Rate: What Your Rupee Actually Buys

Think about this. You walk into a shop in Delhi and see a pair of sneakers for ₹4,000. Your cousin in New York sends you a photo of the same sneakers — they cost $80 there. Which is cheaper? You can't just compare ₹4,000 and $80. You need to convert one into the other using the exchange rate.

If 1 US dollar = ₹83, then $80 = ₹6,640. So the sneakers in Delhi (₹4,000) are cheaper. That's the nominal comparison — just using the market exchange rate.

But what if you're not comparing sneakers? What if you're comparing an entire haircut in India (₹200) versus a haircut in the US ($30)? At ₹83 per dollar, that $30 haircut equals ₹2,490. The Indian haircut is far cheaper. But does that mean everything in India is cheaper? Not exactly. Some things — like imported electronics or petrol — might cost more in India than abroad.

This is where the real exchange rate comes in. It answers a deeper question: After adjusting for the general price level in each country, how many Indian goods can you get for the price of one foreign good?

The Precise Meaning

The real exchange rate (RER) compares the purchasing power of two currencies within their own economies. It tells you the rate at which you can trade the goods and services of one country for those of another.

Let's break this down with a concrete example.

Suppose India is the domestic country and the US is foreign. Let:

• $e = 83$ (₹83 per $1)
• $P_f = 100$ (a basket of US goods costs $100)
• $P_d = 100$ (the same basket of Indian goods costs ₹100)

Then:

$\text{RER} = \frac{83 \times 100}{100} = 83$ …