Nominal & Real Exchange Rate Explained

Nominal Exchange Rate

The Nominal Exchange Rate is the rate at which one country’s currency can be traded for another country’s currency. It’s the current market price for exchanging currencies and is usually quoted in terms of how much foreign currency can be exchanged for a unit of domestic currency or vice versa. This rate fluctuates due to changes in the foreign exchange market.

Example:

Let’s say 1 US Dollar (USD) can be exchanged for 75 Indian Rupees (INR). Here, the nominal exchange rate is 1 USD = 75 INR. If you were to exchange 100 USD, you would get 7,500 INR in return, based on this nominal exchange rate.

Real Exchange Rate

The Real Exchange Rate, on the other hand, adjusts the nominal exchange rate by the relative prices of a standard set of goods and services in the two countries. It essentially measures the purchasing power of one country’s currency relative to another’s. The real exchange rate provides a more accurate picture of the cost of living comparison between two countries.

Example:

Let’s continue with the USD and INR example. Assume the nominal exchange rate is 1 USD = 75 INR. Now, consider a basket of goods that costs 100 USD in the United States. The same basket of goods costs 4500 INR in India.

To calculate the real exchange rate, we use the formula:

Real Exchange Rate = (Nominal Exchange Rate × Price of the basket in home country) / Price of the basket in foreign country

Real Exchange Rate = (75 × 100) / 4500 = 1.67

This means that, after adjusting for the price levels in both countries, 1 USD is effectively worth 1.67 units of the goods and services in India that it could buy in the United States. The real exchange rate provides insight into the relative cost of living and purchasing power between two countries.

Key Differences

• Nominal Exchange Rate is a straightforward comparison of how much of one currency can be exchanged for another currency.
• Real Exchange Rate adjusts the nominal rate for the difference in price levels between countries, offering a more accurate measure of the exchange rate in terms of purchasing power.

Understanding both rates is crucial for economists, businesses, and policymakers as they navigate international trade, investment decisions, and economic policy formulation.