Question

Distinguish between the nominal exchange rate and the real exchange rate. If you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.

Answer 1

Nominal exchange rate is the price of one currency in terms of another. It is the amount of domestic currency required to buy one unit of foreign currency. For example a rupee-dollar exchange rate of Rs 45 means that it costs 45 rupees to buy 1 dollar.

Real exchange rate is the ratio of foreign prices to domestic prices. In other words, it measures foreign prices relative to domestic prices.

Real exchange rate `=(eP_f)/P` 

Where P_f − price level of foreign currency

P − Price level of domestic currency

e − Nominal exchange rate

For example, if a watch costs $40 in US and the nominal exchange rate is Rs 50 per US dollar, then, with real exchange rate of 1, it should cost Rs 2,000 (eP_f = 50 × 40 = Rs 2000) in India.

If, I were to decide whether to buy domestic goods or foreign goods, then real exchange rate will be more relevant, because real exchange rate takes the inflation differential among the countries into account and is also used as an indicator of a country’s competitiveness in the foreign trade.