Explain the difference between the real exchange rate and the nominal exchange rate
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The difference between the real exchange rate and the nominal exchange rate lies in how they are calculated and what factors they take into account.
1. Nominal Exchange Rate:
The nominal exchange rate is the value at which one currency can be exchanged for another. It represents the relative price between two currencies and is determined by the foreign exchange market. This rate is quoted on currency exchanges or financial platforms and can fluctuate frequently based on supply and demand. For example, if 1 US dollar is equal to 0.85 euros, it means that the nominal exchange rate between the two currencies is 0.85.
2. Real Exchange Rate:
The real exchange rate, on the other hand, takes into consideration the difference in the purchasing power of two currencies and adjusts for inflation. It reflects the actual value that can be obtained for a currency in terms of another country's goods and services. The real exchange rate shows the relative price levels between two countries.
To calculate the real exchange rate, you need to use the following formula:
Real Exchange Rate = (Nominal Exchange Rate × Domestic Price Level) / Foreign Price Level
The domestic price level represents the average level of prices in the home country's economy, while the foreign price level represents the average level of prices in the foreign country's economy.
The real exchange rate provides a better measure of the true competitiveness between two countries because it accounts for inflation and adjusts the nominal exchange rate accordingly. A higher real exchange rate means that a currency is overvalued, and goods and services in that country are relatively more expensive compared to foreign goods and services. Conversely, a lower real exchange rate means that a currency is undervalued, and goods and services in that country are relatively cheaper compared to foreign goods and services.
Understanding the difference between the nominal exchange rate and the real exchange rate is important for policymakers, economists, investors, and businesses as it helps to assess the competitiveness of a country's exports and its overall trade balance.