What is the Difference Between Nominal and Real Exchange Rate?
🆚 Go to Comparative Table 🆚The difference between nominal and real exchange rates lies in the fact that nominal exchange rates represent the value of one currency against another, while real exchange rates adjust this value for inflation.
- Nominal Exchange Rate: This is the number of units of the domestic currency that can purchase a unit of a given foreign currency. It is the rate at which currency can be exchanged, and it is usually expressed as the domestic price of the foreign currency.
- Real Exchange Rate: This is the ratio of the price level abroad and the domestic price level, where the foreign price level is converted into domestic currency units via the current nominal exchange rate. The real exchange rate is represented by the following equation: real exchange rate = (nominal exchange rate x domestic price) / (foreign price). It seeks to measure the value of a country's goods against those of another country, a group of countries, or the rest of the world at the prevailing nominal exchange rate.
In summary, the nominal exchange rate focuses on the value of one currency in terms of another, while the real exchange rate considers the inflation-adjusted value of one currency in terms of another. The real exchange rate is considered more relevant when assessing the effect of exchange rates on the economy and international trade.
Comparative Table: Nominal vs Real Exchange Rate
The difference between nominal and real exchange rates lies in their definitions and the factors they consider. Here is a table summarizing the key differences between the two:
| Nominal Exchange Rate | Real Exchange Rate |
|---|---|
| Measures the value of a currency in terms of another currency. | Measures the relative price of goods and services between two countries, taking into account changes in price levels. |
| Reflects the number of units of domestic currency needed to purchase a unit of a given foreign currency. | Represents the ratio of the price level abroad and the domestic price level, with the foreign price level converted into domestic currency units via the current nominal exchange rate. |
| Does not consider inflation or changes in price levels. | Takes into account inflation and changes in price levels. |
| Focuses on the exchange rate between two currencies. | Focuses on the exchange rate between two countries in terms of goods and services. |
| Can be fixed or floating. | Is always floating, even under a fixed nominal exchange rate regime. |
| An increase in the nominal exchange rate is called nominal appreciation, and a decrease is called nominal depreciation. | A decrease in the real exchange rate is called real appreciation, and an increase is called real depreciation. |
In summary, the nominal exchange rate is the rate at which two currencies are exchanged, while the real exchange rate considers the differences in price levels between two countries and the relative purchasing power of their currencies.
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