Difference Between Nominal and Real Exchange Rate

Nominal vs Real Exchange Rate
 

Nominal exchange rate and real exchange rate show the rate at which one currency can be purchased for another. Nominal exchange rates are the rates that are displayed at banks and money changers. Real exchange rates are a bit more complicated and show how many times an item of goods purchased locally can be purchased abroad. The article offers a comprehensive explanation on both types of exchange rates and shows the various similarities and differences between the two.

Nominal Exchange Rate

Nominal exchange rates are the rates at which the currency is exchanged for. Nominal exchange rates are the rates that you find displayed at banks and money changers, and the rate at which you can exchange foreign currency for local currency or vice versa. For example, let’s take the exchange rate between India and the USA as $1 = INR60, this means that a tourist from the States who wants to purchase Indian currency will be able to obtain 60 Indian Rupees for 1 US dollar. Exchange rates are always displayed in terms of the amount of currency that can be purchased for one unit of another currency.

Real Exchange Rate

Real exchange rates measure rate of exchange a bit differently. Real exchange rates show the ratio between the local price levels and price levels in a foreign country. Real exchange rates shows how much of goods and services purchased in one country can be exchanged for goods and services of another country. The equation for calculating real exchange rates are, real exchange rate = nominal exchange rate X domestic price / foreign currency. Let’s take an example to explain this clearly. You need to know the rate of 1 kg of rice between the US and India. Let’s assume the price of 1kg of rice in India as 80 INR, and the price of 1kg of rice (of equivalent quality) in US as $4. The exchange rate is $1 = INR60. This will be calculated as, real exchange rate = 60 × 4 / 80 = 3.

What is the difference between Nominal and Real Exchange Rate?

Real exchange rates and nominal exchanges rates should be calculated as they provide a comprehensive overview of the rate of currency exchange between two countries. Nominal and real exchange rates are also important for countries to compare levels of costs of living. A high nominal exchange rate may show the local currency can purchase more foreign goods and services. However, this may not be the case when the real exchange rate between the two is calculated. Real exchange rates may be more useful when assessing the impact of exchange rates on international trade than nominal exchange rates as it shows how many times an item of goods can be bought abroad.

Summary:

Nominal Exchange Rate and Real Exchange Rate

• Nominal exchange rates are the rates at which the currency is exchanged for. Nominal exchange rates are the rates that you find displayed at banks and money changers, and the rate at which you can exchange foreign currency for local currency or vice versa.

• Real exchange rates shows how much of goods and services purchased in one country can be exchanged for goods and services of another country.

• Nominal and real exchange rates are important for countries to compare levels of costs of living. A high nominal exchange rate may show the local currency can purchase more foreign goods and services. However, this may not be the case when the real exchange rate between the two is calculated.

• Real exchange rates may be more useful when assessing the impact of exchange rates on international trade than nominal exchange rates as it shows how many times an item of goods can be bought abroad.