It is not possible to say whether a country’s exchange rate is “high” or “low” by looking at the nominal rate. That one dollar corresponds to 20, 50 or 100 units of the domestic currency does not, by itself, show that the currency is expensive or cheap. Nominal values are the outcome of many factors, including past inflation, currency reforms, the price level and the exchange-rate regime.
Three concepts matter in this assessment:
a) The nominal exchange rate is the price of foreign currency in units of domestic currency.
b) The real exchange rate is obtained by adjusting the nominal rate for differences in price levels across countries.
c) The equilibrium exchange rate refers to the rate judged to be consistent with the current-account balance, productivity, external indebtedness, capital flows, the risk premium and policy conditions.
Accordingly, the labels “overvalued” and “undervalued” do not rest on a single indicator.
1. Inflation differentials and purchasing-power parity
The most basic approach is purchasing-power parity (Purchasing Power Parity = PPP). On this view, exchange rates reflect differences in price levels across countries over the long run. If prices rise faster in one country than in another, that country’s currency is expected to depreciate in nominal terms.
Purchasing-power parity predicts that, over the long run, the nominal exchange rate will adjust to the inflation differential between countries. The approximate relative-PPP formula is %ΔE = πTR − πUS. Here E is the TRY/USD nominal rate, πTR is inflation in Türkiye and πUS is inflation in the United States. For example, if inflation is 30 percent in Türkiye and 3 percent in the United States, the lira is expected to depreciate against the dollar by roughly 27 percent. A more precise calculation is E1/E0 = (1+πTR)/(1+πUS) = 1.30/1.03 = 1.262. If the starting rate is 40 TRY/USD, a rate close to equilibrium is about 40 × 1.262 = 50.48 TRY/USD. If the rate remains at 40 TRY, prices in Türkiye have risen faster than in the United States, so the lira is regarded as having appreciated in real terms. Thus, if the rise in the nominal rate does not offset the inflation differential, the domestic currency has appreciated in real terms. PPP is an approach used more for long-run equilibrium and real-valuation analysis than for short-term exchange-rate forecasting.
%ΔE = πTR − πUS
E1 / E0 = (1 + πTR) / (1 + πUS)
40 × (1.30 / 1.03) = 50.48 TRY/USD
In short-term exchange-rate forecasting, the market rate may deviate from the level required by PPP because of non-tradable goods and services, taxes, transport costs, capital flows and the risk premium. Even so, PPP remains a useful indicator, especially over longer horizons, of whether the domestic currency has become relatively more expensive.
2. The real effective exchange rate
In practice, one of the most useful indicators is the real effective exchange rate (REER) index. The nominal effective exchange rate shows the weighted value of the domestic currency against a basket of currencies of countries with a significant share in external trade. The real effective rate adjusts that nominal value for relative price movements. In the Central Bank of the Republic of Türkiye (CBRT) methodology, an increase in the REER means a real appreciation of the Turkish lira, and a decrease means a real depreciation (CBRT, 2026).
A general reading such as “below 100 is cheap, above 100 is expensive” is not correct for the REER. What is more meaningful is to examine the current index together with its own historical average, its trend and indicators of competitiveness. If the nominal rate rises while domestic prices increase faster than foreign prices, the domestic currency may appreciate in real terms even as it depreciates nominally.
The real effective exchange rate (REER) is an indicator that takes into account not only the value of a country’s currency against a single foreign currency, but also its average value against the currencies of its trading partners and differences in price levels across countries.
The basic calculation
Bi,t = Pt / (Ei,t × P*i,t)
REER*t = ∏i (Bi,t)wi
REERt = 100 × REER*t / REER*(base period)
| Symbol | Meaning |
|---|---|
| Pt | The price level in Türkiye (for example the CPI index) |
| P*i,t | The price level in country i |
| Ei,t | The nominal exchange rate of country i’s currency in lira terms |
| wi | Country i’s weight in Türkiye’s external trade; the weights sum to 1 |
| ∏ | Indicates that the bilateral real rates calculated for each country are combined geometrically |
The calculation can be summarised in three steps: (1) the lira’s real bilateral value is found for each trading partner; (2) these values are weighted by the countries’ shares in external trade and combined as a geometric mean; (3) the result is indexed so that it equals 100 in the chosen base period.
Interpretation: in the presentation used by the CBRT, a rise in the REER index means that the lira has appreciated in real terms; a fall means that the lira has depreciated in real terms. For example, a rise in the index from 95 to 105 points to a real appreciation of the lira relative to the base period and to trading partners.
In short: REER = the trade-weighted combination of nominal exchange rates + an adjustment for relative price levels across countries. The REER therefore captures not only a market rate such as USD/TRY, but also inflation differentials and the weights of trading partners.
3. Foreign trade and the current-account balance
The exchange-rate level should also be tested against foreign trade and the current-account balance. In an economy where the domestic currency remains overvalued for a long period, imports become relatively cheaper, the price competitiveness of exports may weaken and the current-account deficit may widen. Real depreciation, under suitable conditions, may support exports and restrain import demand. Energy imports, dependence of production on imported inputs and strong domestic demand can, however, weaken this relationship. A current-account deficit therefore does not, by itself, yield the conclusion that “the exchange rate should not be at this level”; it is nonetheless an important complementary indicator.
For competitiveness, unit labour costs and productivity should be monitored alongside consumer prices. If wages in domestic-currency terms rise rapidly, productivity does not increase to the same extent and the rise in the exchange rate lags behind the rise in costs, exporters’ production costs in foreign-currency terms increase. In that case the country may become more expensive in real terms even if the nominal exchange rate has risen.
4. The risk premium, capital flows and the equilibrium exchange rate
A currency may depreciate further even if it looks “cheap” by PPP or REER measures. The exchange rate is determined not only by goods and services prices but also by financial markets. A rise in the country risk premium, pressure from external-debt repayments, weaker reserves, capital outflows, low real interest rates or policy uncertainty exert additional depreciation pressure on the domestic currency. Financial sustainability should therefore also be taken into account when judging a reasonable level of the exchange rate.
At this point the concept of the equilibrium exchange rate comes to the fore. The equilibrium rate is the real exchange rate judged to be consistent with the economy’s medium-term fundamentals. The IMF’s External Balance Assessment evaluates external positions by using different models together, including the current-account balance, the real effective exchange rate and external sustainability (Phillips et al., 2013; Allen et al., 2023). A view on whether the exchange rate is expensive or cheap should emerge from multidimensional macroeconomic analysis, not from a single parity calculation.
The sound way to tell whether a country’s exchange rate is “high” or “low” has three stages: first the path of the nominal rate is observed; then a real valuation is made with the help of the inflation differential and the REER; finally a view on the equilibrium rate is reached by taking into account the current-account balance, productivity, external indebtedness, the risk premium, reserves and capital flows.
References
- Allen, C., Casas, C., Ganelli, G., Juvenal, L., Leigh, D., Rabanal, P., Rebillard, C., Rodriguez, J. & Tovar Jalles, J. (2023). 2022 Update of the External Balance Assessment Methodology. IMF Working Paper No. 2023/047.
- Phillips, S., Catão, L., Ricci, L., Bems, R., Das, M., Di Giovanni, J., Unsal, D. F., Castillo, M., Lee, J., Rodriguez, J. & Vargas, M. (2013). The External Balance Assessment (EBA) Methodology. IMF Working Paper No. 2013/272.
- Central Bank of the Republic of Türkiye (CBRT). (2026). Methodological Notes on Real Effective Exchange Rate Indices. Ankara: CBRT.
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