What is the nominal and real exchange rate? (2024)

The nominal exchange rateEis defined as the number of units of the domestic currency that can purchase a unit of a given foreign currency. A decrease in this variable is termed nominal appreciation of the currency. (Under the fixed exchange rate regime, a downward adjustment of the rateEis termed revaluation.) An increase in this variable is termed nominal depreciation of the currency. (Under the fixed exchange rate regime, an upward adjustment of the rateEis called devaluation.)

By contrast, the real exchange rate R is defined as the ratio of the price level abroad and the domestic price level, where the foreign price level is converted into domestic currency units via the current nominal exchange rate. Formally,R=(E.P*)/P, where the foreign price level is denoted asP*and the domestic price level asP. A decrease inRis termed appreciation of the real exchange rate, an increase is termed depreciation. The real rate tells us how many times more or less goods and services can be purchased abroad (after conversion into a foreign currency) than in the domestic market for a given amount. In practice, changes of the real exchange rate rather than its absolute level are important. In contrast to the nominal exchange rate, the real exchange rate is always ”floating”, since even in the regime of a fixed nominal exchange rateE, the real exchange rateRcan move via price-level changes.

Rather than focusing on the nominal exchange rate, it is more sensible to monitor the real exchange rate when assessing the effect of exchange rates on international trade or export competitiveness of a country. For simplicity, assume that the domestic price level rises by 10%, the foreign price level remains unchanged and the domestic currency depreciates nominally by 10%. Then the real exchange rate, i.e. the ratio of prices at home and abroad, remains unaffected, depreciation of the domestic currency notwithstanding. Other things held equal in our simplified framework, there would be no change in the demand for imports in the domestic economy and in the demand for exports of the domestic economy abroad.

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What is the nominal and real exchange rate? (2024)

FAQs

What is the nominal and real exchange rate? ›

The real exchange rate (RER) between two currencies is the product of the nominal exchange rate (the dollar cost of a euro, for example) and the ratio of prices between the two countries.

What is the difference between a nominal exchange rate and a real exchange rate quizlet? ›

A nominal exchange rate measures the value of one country's currency in terms of another country's currency. A real exchange rate measures the price of domestic goods in terms of foreign goods.

Do nominal and real exchange rates move together? ›

The correlations between nominal and real exchange rates are very high. Also remarkably high, and newly discovered here, are the correlations between real exchange rates and cross-country relative outputs, which suggests the dominance of real supply shocks over real demand shocks for real exchange rate behavior.

What is an example of a nominal effective exchange rate? ›

A nominal exchange rate is essentially the relative prices between two currencies. For example, if an exchange rate is listed as 1 euro = 1.10 USD, then one euro can be exchanged on the currency exchange market for 1.1 U.S dollars.

Which of the following is an example of nominal exchange rate? ›

Usually, nominal exchange rates are bilateral, which means they denote the number of units of one country in terms of one unit of another; for example, two US dollars to one UK pound; or 0.50 UK pounds to one US dollar.

Why are nominal and real prices the same? ›

The real value of an item, also called its relative price, is its nominal value adjusted for inflation and measures that value in terms of another item. Real values are more important than nominal values for economic measures, such as gross domestic product (GDP) and personal incomes.

What is nominal exchange rate also called? ›

The nominal exchange rate is the amount of domestic currency needed to purchase foreign currency. In economics, the NEER is an indicator of a country's international competitiveness in terms of the foreign exchange (forex) market. Forex traders sometimes refer to the NEER as the trade-weighted currency index.

What determines nominal exchange rate? ›

In modern models of exchange rate determination, the exchange rate, being the relative price of two national monies, is determined primarily by the relative supply of and demand for these monies.

What happens when the nominal exchange rate falls? ›

This is so because as the nominal exchange rate falls the domestic currency rises in value. This is an appreciation of the domestic currency. As this currency rises in value (after appreciation) it can buy more of the foreign currency at every unit than it could at the previous exchange rate.

What does an increase in nominal exchange rate mean? ›

What is nominal effective exchange rate (NEER)? NEER is a measure of the value of a currency against a weighted average of several foreign currencies. An increase in NEER indicates an appreciation of the local currency against the weighted basket of currencies of its trading partners.

Why is the nominal exchange rate important? ›

The nominal exchange rate plays a significant role in shaping a country's monetary and fiscal policies. Changes in the rate can profoundly affect a country's economic stability with implications for inflation rates, interest rates, and output levels.

What happens when the real exchange rate increases? ›

An increase in REER implies that exports become more expensive and imports become cheaper; therefore, an increase indicates a loss in trade competitiveness.

What determines the real exchange rate and the nominal exchange rate in the long run? ›

In the long run - that is, after all nominal prices adjust to their equilibrium levels - the real exchange rate is expected to be determined by real factors only, such as technology and preferences.

What are real exchange rates examples? ›

The real exchange rate is the current price businesses and consumers will pay to buy a foreign product using their home currencies. For example, if the current U.S. exchange rate between the U.S. and Britain was $138 U.S. dollars for one pound, an American consumer would need $1.38 to buy one pound worth of goods.

How do exchange rates work for dummies? ›

The exchange rate gives the relative value of one currency against another currency. An exchange rate GBP/USD of two, for example, indicates that one pound will buy two U.S. dollars. The U.S. dollar is the most commonly used reference currency, which means other currencies are usually quoted against the U.S. dollar.

What is the difference between the nominal interest rate and the real interest rate quizlet? ›

the nominal interest rate is the stated interest rate whereas the real interest rate is the nominal interest minus the inflation rate.

What is the difference between the nominal money interest rate and the real interest rate quizlet? ›

The nominal interest rate is the rate you pay on a loan. The real interest rate is the nominal interest rate adjusted for inflation.

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