Exchange Rates: Measurement of Exchange Rates - Nominal vs. Real

This section explores how exchange rates are measured, focusing on the crucial distinction between nominal and real exchange rates. Understanding this difference is fundamental to analyzing international trade and investment.

Nominal Exchange Rates

A nominal exchange rate represents the price of one currency expressed in terms of another. It's the rate at which one currency can be exchanged for another. For example, if the nominal exchange rate between the pound sterling (GBP) and the US dollar (USD) is 1 GBP = 1.25 USD, it means that one pound can buy 1.25 dollars.

Nominal exchange rates are typically quoted as:

• Direct quote: The amount of the foreign currency required to buy one unit of the domestic currency (e.g., GBP/USD = 1.25).
• Indirect quote: The amount of the domestic currency required to buy one unit of the foreign currency (e.g., USD/GBP = 0.80).

The choice of quote depends on convention, but the underlying information is the same.

Real Exchange Rates

A real exchange rate goes beyond the nominal exchange rate by incorporating price level differences between two countries. It indicates the relative purchasing power of goods and services in the two countries. It tells us how much a basket of goods from one country costs in terms of a basket of goods from another country.

The formula for the real exchange rate is:

$$ R = \frac{P_1}{P_2} \times E $$

Where:

• $R$ is the real exchange rate.
• $P_1$ is the price level in the domestic country.
• $P_2$ is the price level in the foreign country.
• $E$ is the nominal exchange rate (domestic currency per unit of foreign currency).

If the real exchange rate increases, it means that goods in the domestic country are relatively more expensive compared to goods in the foreign country. This makes domestic goods less competitive.

Distinction: Nominal vs. Real Exchange Rates

| Feature | Nominal Exchange Rate | Real Exchange Rate |

Feature	Description
Definition	Price of one currency in terms of another.
Incorporates	Only the exchange rate between currencies.
Reflects	The cost of exchanging currencies.
Price Level Differences	Does not account for differences in price levels between countries.
Purchasing Power	Does not directly reflect the relative purchasing power of goods and services.
Formula	Direct or indirect quote (e.g., GBP/USD = 1.25).
Formula	$R = \frac{P_1}{P_2} \times E$

Impact of Exchange Rate Changes

Changes in exchange rates have significant implications for international trade and investment. A depreciation of a country's currency (i.e., the nominal exchange rate increases) makes its exports cheaper and imports more expensive. Conversely, an appreciation makes exports more expensive and imports cheaper.

The real exchange rate provides a more nuanced understanding of these effects by considering the impact of price level differences. A depreciation might not necessarily improve a country's trade balance if the price level in that country is also rising significantly.

Example

Suppose the nominal exchange rate between the US dollar (USD) and the Euro (EUR) is 1 USD = 0.90 EUR. The price level in the US is 100 and in the Eurozone is 90. The real exchange rate is:

$$ R = \frac{100}{90} \times 0.90 = 1.00 $$

A real exchange rate of 1.00 means that a basket of goods costing $100 in the US costs €90 in the Eurozone, which is consistent with the nominal exchange rate and price level differences.