Comparison Essay: Nominal Vs Real Exchange Rate

Nominal and real exchange rates are the main types of exchange rates used in international trade and foreign exchange market. Nominal rate refers to the value of a currency that can be traded for a single unit. It can also be defined as the rate at which one currency trades for another in a foreign exchange market.

Real exchange rate on the other hand refers to the amount of products or services in a given state that can be traded for a single unit of the same good or service in a different country. It is the nominal exchange rate adjusted for inflation and measures the purchasing power of a local currency in a common exchange. For instance, real exchange rate can be the number of wine bottles from the US traded for a single bottle of the same wine from Italy.

Real exchange rate gives an ideal picture of competitiveness of local products and services across global markets. In particular, a decrease in real exchange rate increases competitiveness of a local product in a global market. For this reason, it is measured by multiplying nominal exchange rate to the ratio of foreign price level to domestic price ratio.

While making comparison between the two types of exchange rates, it is essential to note that real exchange rate is focused on goods and services while nominal exchange rate is mainly based the value of currency. Therefore, reach exchange rate is reached at by multiplying nominal exchange rate to the domestic value. In simple terms

Nominal exchange rate- is the amount of cash or currency you can receive in exchange for another currency

Real exchange rate- is the purchasing power of a currency relative to another at current exchange rates and prices.

Nominal vs real exchange rate

Both nominal and real exchange rate can be dependent on while trying to determine the cost of living in two countries, trading together as partners. With a high real exchange rate, there is an indication that one domestic currency unit can be used to purchase a large amount of foreign products. A nominal exchange rate cannot be used for the same purpose or justification.

A high real exchange rate increases imports and decreases exports at the same time and vice versa. This is based on the fact that the relative price of different products in the local market can be pushed higher and that of products abroad can be decreased in the event of high real exchange rate. Nominal exchange rate does not have such features.

A nominal exchange rate is not influenced by price change or the value of goods and services that can be purchased by different currencies. Even so, changes can only take place over a specific period of time because of night shifts in a given currency’s value. What’s more, changes can occur due to the prices of related products that the currency can obtain. It is also usually set in an open market and depends on the amount of currency that can be traded by another currency.

Determining nominal and real exchange rate

When determining real exchange rate, the end result derived usually includes adjustments for effects of inflation. The figures factor in a wide range of transaction costs including tariffs among others that relate to importation of goods. Real exchange rate is also a true a reflection of the amount of cash that consumers pay to purchase imported items.

On the other hand, nominal exchange rate only offers estimation on relative prices that consumers will pay for imported goods. This means that it is often an assumption that the value or price of imported goods by consumers can be contrary to their anticipations.

Therefore, by using real exchange rate and nominal exchange rate, it can be easy to deduce important information about the cost of living in two different countries. A high nominal exchange rate can easily create a false picture that domestic currency unit will purchase many foreign commodities but in the real sense, only a high real exchange rate can justify such information.

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Sources

https://www.boundless.com/economics/textbooks/boundless-economics-textbook/open-economy-macroeconomics-32/exchange-rates-130/real-versus-nominal-rates-516-12612/

http://www.sparknotes.com/economics/macro/trade/section3.rhtml