b) REAL EXCHANGE RATEBasically, the real exchange rate can be defined as the nominal exchange rate thattakes the inflation differentials among the countries into account. Its importancestems fromthe fact that it can be used as an indicator of competitiveness in the foreigntrade of a country.The Real Exchange Rate DefinitionsThe various definitions of the real exchange rate can mainly be categorized undertwo main groups. The first group of definitions is made in line with thepurchasing powerparity. The second group of definitions, on the other hand, is based on thedistinction betweenthe tradable and the non-tradable goods.Purchasing Power ParityAccording to this definition, the real exchange rate can be defined in the longrun asthe nominal exchange rate (e) that is adjusted by the ratio of the foreign pricelevel (Pf) to thedomestic price level (P). Mathematically, it can be shown as In terms of this definition, the decline in the rppp can be interpreted as therealappreciation of the exchange rate.The Definition on the Basis of the Tradable and Non-tradable GoodsThis definition takes the relative price of the tradables and non-tradables in thecountry as an indicator of the country’s competitiveness level in the foreigntrade. Therationale behind this definition is that the cost differential between thecountries are closelyrelated with the relative price structures in these economies.Under the assumption that the prices of the tradables will be equal all around theworld, the real exchange rate defined on the basis of tradable and non-tradablegoodsdistinction can be mathematically represented as: In this definition, Pt and Pt* stand for the domestic and international prices ofthetradables respectively, while the prices of the non-tradables are denoted by Pn.In thisdefinition, the decline of rr indicates the real appreciation of the domesticcurrency.TRADE WEIGHTED EXCHANGE RATEIt is also known as the effective exchange rate, and is a multilateral exchangerate which is a weighted average of exchange rates of home and foreign currencies,with the weight for each foreign country equal to its share in trade. It measuresthe average price of a home good relative to the average price of goods of tradingpartners, using the share of trade with each country as the weight for thatcountry.