Nominal and Real Exchange Rates
Nominal and Real Exchange Rates
By Raphael Zeder | Last updated Jun 26, 2020 (Published Jun 14, 2020)
Exchange rates define the value of a currency in relation to other currencies. Therefore, they are essential determinants for international trade. After all, exchange rates have a significant impact on how cheap or expensive foreign goods or services are, relative to domestic prices.
Starting from there, we can measure two types of exchange rates: nominal and real exchange rates. We will look at the meaning and purpose of this distinction in more detail below.
1. Nominal Exchange Rates
The nominal exchange rate describes the rate at which an individual can trade the currency of one country for the currency of another country. That means it measures how much of currency B can be bought in exchange for currency A or vice versa.
Starting from there, all exchange rates can be expressed in two different ways, depending on the base currency we chose. That means we can either measure how much of currency B we get in exchange for currency A or measure how much of currency A we receive in exchange for currency B.
To illustrate this, let’s say you go to a bank to exchange USD 100 to EUR. The bank offers you EUR 0.88 per USD, i.e., USD 1.00 is worth EUR 0.88 at this time. That means you can get EUR 88 in exchange for USD 100 (i.e., 100 x 0.88). Of course, you can always change your EUR 88 back to USD if you want. In that case, the bank offers you USD 1.14 per EUR.
Note that the exchange rate looks different because it uses the EUR as the base currency instead of USD. However, it’s pretty much the same thing (if we ignore the rounding error). So, with this exchange rate, you can get your initial USD 100 back, in exchange for EUR 88 (i.e., 88 x 1.14).
However, please note that the bank won’t actually use the exact same exchange rate for buying and selling a currency. It will charge slightly different prices, which is how it generates profits from offering exchange services.
2. Real Exchange Rates
The real exchange rate describes the rate at which an individual can trade the goods and services of one country for the goods and services of another country. That means it describes how much of a foreign good or service can be exchanged for one unit of a domestic product.
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