Real Effective Exchange Rate

The real effective exchange rate is essentially the simplistic exchange rate adjusted for inflation making the exchange rate more useful in measuring foreign competitiveness. An increase in inflation leads to a decrease in the value of the currency and the possible increase in the country's trade balance as a result of increased exports due to cheaper prices. Venezuela and Japan show the connection between trade balance and inflation rates, Venezuela with a positive trade balance and Japan with a negative balance

The nominal exchange rate is the relative price of one currency to another for example the dollar depreciates with respect to the pound so the dollar will buy less pounds, the opposite is true for appreciation. The real effective exchange rate (REER) takes the nominal exchange rate and adjusts the rate to account for inflation or deflation among the countries. The REER can be used to judge a country's competitiveness of their foreign trade. The Central Bank's short term capital flows are sensitive to changes in the exchange rate and in turn their net foreign assets are affected, because that is a balance sheet account something on the liability side must change as well. The volume of currency in circulation changes in relation to the net foreign assets difference, in order to reach the target of price stability the Central Bank must use the correct monetary policy tools (Kıpıcı 1997). According to Kıpıcı and Kesriyeli (1997) there are two main categories that the numerous definitions fit under, the first have to do with the purchasing power parity and the other is based on the difference between tradable and non-tradable goods.

Purchasing power parity (PPP) is the idea that identical goods and services sold in different countries should cost the same where ever they are sold. This theory is clearly only applicable to tradable goods and assumes there are competitive markets for the goods and services in the involved countries. A Mexican automaker sells their vehicles (for simplicity's sake) for 100 pesos and say 1 American dollar is worth 5 pesos the car would cost $20 the same car is sold for $50 in the U.S. those consumers would instead go to Mexico to buy their cars. If people caught on and a large amount of U.S. consumers bought directly from Mexico the inflow of dollars would drive the price of the peso up until the price of the car is the same in Mexico and America. However this theory disregards things like tariffs, transportation, and transaction costs which play a part in how goods and services are priced when sold abroad. Kıpıcı and Kesriyeli (1997) state that the real exchange rate can be calculated by taking the exchange rate and adjusting it by the quotient of the foreign price level divided by the domestic price level. According to this an increase in the quotient means there has been a real depreciation of the rate (Kıpıcı 1997).

One of the reasons the real exchange