Real exchange rate formula

External question — Economics Stack Exchange Author: secretrevaler Original post: https://economics.stackexchange.com/questions/60438 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. The real exchange rate is defined as: $S_{\frac{d}{f}} * \frac{CPI_f}{CPI_d}$ where d is the domestic currency and f is the foreign currency. I have two questions about this: Why do we use CPIs instead of the prices of the two baskets of goods? Do we assume the basket of goods are the same between the two countries? I don't see how this holds otherwise.

External answer — Economics Stack Exchange Author: Don Original post: https://economics.stackexchange.com/a/60439 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. Why do we use CPIs instead of the prices of the two baskets of goods? This is exactly the definition of CPI. From the US Bureau of Labor Statistics "The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.". This means that the CPI at instant $t$ represents the price of the market basket at time $t$ , and it is typically used to measure change over time of these prices (inflation), but it is not a change itself. Do we assume the basket of goods are the same between the two countries? I don't see how this holds otherwise. No, CPI across countries are not (can not) be the same, since different countries have different consumption patterns. However, it is typically assumed that they are somehow cross-country comparable. Yes, this undermines a bit the validity of the real interest rates as an economic indicator, and they should be read together with other indicators.