Exchange Rates: Nominal and Real: Study with Video Lessons, Practice Problems & Examples

The nominal exchange rate is the current rate at which one currency trades for another, while the real exchange rate focuses on purchasing power, comparing how many goods can be bought in different countries. Currency appreciation occurs when a currency can buy more foreign currency, while depreciation means it buys less. The real exchange rate can be calculated using the formula: Foreign⁢CurrencyUS⁢Currency⁢US⁢Price⁢Foreign⁢Price. Understanding these concepts is crucial for analyzing international trade and economic conditions.

Nominal and Real Exchange Rates

So we talk about nominal and real a lot in this class. Let's see how it applies to exchange rates. So the nominal exchange rate is the rate at which one currency trades for another. It's just the current exchange rate, the rate at which one currency trades for another right now. Okay? So when we think about nominal exchange rates, it's like when you go to the bank and they tell you, you can trade 108 Japanese yen for 1 US dollar. So if you go to the bank and you give them $1, they will give you 108 yen, right? They'll give you 108 yen for that $1. That's the nominal exchange rate. So we say a currency appreciates, there's currency appreciation when your currency can buy more of the foreign currency. So now you can imagine instead of offering 108 yen per US dollar, what would be a number where you get, where the dollar has appreciated? So, you would be able to get more yen, right? The currency would appreciate, the US dollar would appreciate when you can get more yen for that dollar. So now the bank offers you say, a 112 yen for 1 US dollar instead of 108 before, now you're getting 112, you're getting more yen per dollar. Your dollar has appreciated. The opposite is depreciation when your currency can buy less of the foreign currency. So now you go to the bank and you say, hey, let me get all that yen you were offering. And now they come up to you and say, oh, today you can only get 102 yen. You only get 102. Now your dollar has depreciated, right? You're getting less of the foreign currency based on the exchange rate, right? So the nominal exchange rate determines what the exchange rate is and then a currency appreciates when you get more of that foreign currency or depreciates when you get less of it, okay? So I want to make a note that when one currency appreciates, the other depreciates. Okay? The other currency depreciates always. There's always this vice versa effect. Because if the dollar got stronger, that means that the yen got weaker compared to the dollar, right? Because if you walked into the bank here where the currency appreciated and you walked in with $1 and they gave you 112 yen, Well, if someone went into the bank and went in with yen, they would need 112 yen to get $1, right? So the yen, it got more expensive to dollars. Their yen got depreciated when the US dollar appreciated. There's always this vice versa balance going on, okay? So that's the nominal exchange rate. That's basically the current exchange rate on the market. But now when we talk about real exchange rates, well, we're taking out the idea of how much one currency, compared to the other and we're focused more on how much goods cost in each country. So rather than the price of the currency, we're focused on the price of domestic goods in terms of foreign goods. Okay? So now we're thinking, okay, in the US you can buy how many Big Macs for the same amount of money that you can buy Big Macs in a foreign country. Or how many, basically any product, right? How many gallons of milk can you get in the US for the same amount of money that you would exchange and get in a foreign country. So let's look at the example here. So Real Exchange Rate, it focuses on purchasing power, right? How much stuff can you get with the same amount of equivalent money in both countries? So let's see this example where we're thinking about the cost of sandwiches. So cost of a sandwich in the US is $3 And that same sandwich costs £1.5 So it sounds like you've got a good deal if you go to Britain, right? There's only 1.5 is the price in Britain compared to $3 in the US. But what we have to focus on is that exchange rate. How much is the exchange rate and how much can we actually get of each good? So if the exchange rate is 0.5 British pounds per US dollar, what is the real exchange rate? So now we're thinking about how many sandwiches we can get with the same amount of money in each country. Okay? So the way we do this is we're going to take the exchange rate we have. We're gonna take the 0.5 Great British Pounds divided by the 1 US dollar, okay? And what we're gonna do is we're gonna multiply it by the price of the goods. So what we're going to do, we'll multiply it by the price of the goods because the goods is almost in its own sense, its own exchange rate, right? You could buy a sandwich in the US for $3 How many sandwiches will you get in Great Britain with those same money, okay? So what we're gonna do is we're gonna put the US on top because we want all of the units to cancel. US dollars on top,31.5 Great British Pounds. Notice, we've got pounds on the top, pounds on the bottom, dollars on the bottom, dollars on the top and all the units cancel. And we're left in terms of sandwiches now. We're left in sandwich terms in the amount of goods. So when we do all this math, 0.51 multiplied by 31.5, In this case, we get 1. One sandwich. That means in the US and Great Britain you get 1 sandwich in either place. The exchange rate is 1, the real exchange rate is 1 sandwich in the US for 1 sandwich in Great Britain. Now let's look at the next example where a sandwich costs $3 in the US and the cost is 1.5. And the way that worked was because look, the price of a sandwich here was double the price in pounds, right? And the exchange rate was half, half of 1 pound for $1. But now when we don't make it so even, we'll see that the real exchange rate can be different. So now a sandwich costs $3 in the US and costs 1.5 British pounds, right? The same as before, but the exchange rate is now 0.6 British pounds per US dollar. So before we move on, did the dollar get stronger or weaker? Did the dollar appreciate get stronger or depreciate get weaker compared to the previous example? The dollar appreciated, right? Because before you went to the bank and said, here's a dollar, give me pounds and they gave you half a pound. Now, you go to the bank with a dollar and they give you 0.6. You get more pounds per dollar. So if you think about it, before, you were getting 1 sandwich for 1 sandwich there. But now, since the dollar is stronger and the prices of sandwiches have remained the same, you would imagine that you can get more sandwiches in Great Britain than you did before. So let's go ahead and see how this works out in the math. So now our exchange rate is 0.6, Great British pounds divided by 1 US dollar times now, we wanna do the exchange rate of the sandwiches. 31.5 Great British pounds there. And again, all of our units cancel, US dollars with US dollars, pounds with pounds, and now let's do this exchange rate. So now let's see what our real exchange rate is. 0.61 multiplied by 31.5. So now our exchange rate is 1.2 sandwiches in this case. Okay? So now what this tells us is that the US can use, can take one sandwich in the US and go to Great Britain and get 1.2 sandwiches. Okay? 1.2, Great British sandwiches for every one US sandwich. Okay. So notice, we're focused on goods rather than dollars and pounds now. Because we want to see the purchasing power of these currencies. So since the dollar got stronger here, the US can buy more sandwiches with their currency in Great Britain, okay? So sometimes it's one thing to say, oh, we got, we can get more pounds or less pound. But really we want to focus on how much can we purchase because if the prices are way more expensive overseas, even if we're getting more money, well, it doesn't really mean we're getting more stuff for our money. Okay? So that's the idea of the real exchange rate. Okay? We have a formula for our real exchange rate here. It's where we're going to take our nominal exchange rate like we were doing up here in US dollars. So great British pounds to US dollars, right? Foreign currency divided by US currency and then we'll multiply it by the opposite in the price levels, so that we can cancel out all of our units and be left with just value of goods, okay? So that's what we WideString. Remember, this is foreign currency, so this nominal exchange rate in US dollars is foreign currency divided by US dollars. Okay? Foreign currency divided by US dollars times US dollar prices over foreign currency prices and then they all cancel out those units

The exchange rate between the USD and GBP is currently $1.61 = 1 GBP. If the price level in the US is 108 and the price level in the United Kingdom is 114, what is the real exchange rate?

Alright. So let's see how you guys did here with this real exchange rate. The exchange rate between the US dollar and Great British pounds is currently 1.61 equals 1 Great British pound. So that's our nominal exchange rate right there, right? That's what you can get at the bank. If the price level in the US is 108, so now we're talking about prices in general, not just one sandwich but the price level. This takes into account all the prices in the US are currently 108, that is our Consumer Price Index (CPI) in the US, and the price level in the United Kingdom is 114. What is the real exchange rate? Okay, so we're going to use that same method and instead of just having the prices of sandwiches, we have the total price level for the whole economy, alright? So let's start with our nominal exchange rate. Remember we want these two things. We want our nominal exchange rate in US dollars and then our price levels in, the opposite way with the US dollars on top. So our nominal exchange rate in US dollars is going to be 1 Great British pound divided by 1.61 US dollars. Remember, when we say in US dollars, we want the US dollars in the denominator. So now, we want to multiply it, by our price levels. We want the 108 which is in US dollars up here and the 114 which is in Great British pounds down here. And now, we can cancel out all our units and we're left with our real exchange rate, which is just the value of goods. Okay? So let's do our math here which is 11.61. 11.61 × 108114 and we get 0.588. Okay? So our real exchange rate is that you can get 0.588 goods in the US for every good in the Great British Great in United Kingdom. So things are much more expensive in the United Kingdom than they are in the US. Okay? So we did 11.61 × 108114. Yep. 0.588. Okay. So that tells us that, for every one good you can buy in the US, you can only get 0.588 goods in Great Britain. Okay? So for every one good, whatever this value of good is in the US, if you were to try and buy the same thing in Great Britain, you'd only get 0.58 of that good. So you go to buy an apple in the US, you'd get a full apple. You go with that same value to Great Britain and you'd have a half eaten apple with only 0.58 of the apple there. Okay? So that's exactly what's going on here with the real exchange rate. Okay? So it not only takes into account the nominal exchange rate, it takes into account the price levels in each country as well. Okay? So there we go. That's the real exchange rate. Let's go ahead and move on to the next.

Here’s what students ask on this topic:

What is the difference between nominal and real exchange rates?

The nominal exchange rate is the current rate at which one currency trades for another. It tells you how much of one currency you can get in exchange for another currency at the present moment. For example, if 1 USD can be exchanged for 108 JPY, that is the nominal exchange rate. On the other hand, the real exchange rate focuses on purchasing power. It compares the amount of goods that can be bought in different countries with the same amount of money. The real exchange rate is calculated using the formula:

Foreign⁢CurrencyUS⁢Currency⁢US⁢PriceForeign⁢Price

This helps in understanding the true value of money in terms of goods and services across different countries.

How does currency appreciation and depreciation affect exchange rates?

Currency appreciation occurs when a currency can buy more of a foreign currency. For example, if the USD appreciates against the JPY, you might go from getting 108 JPY per USD to 112 JPY per USD. Conversely, currency depreciation happens when a currency buys less of a foreign currency. Using the same example, if the USD depreciates, you might only get 102 JPY per USD instead of 108. When one currency appreciates, the other depreciates. This inverse relationship affects international trade, as a stronger currency makes imports cheaper and exports more expensive, while a weaker currency has the opposite effect.

How do you calculate the real exchange rate?

The real exchange rate is calculated to understand the purchasing power of one currency in terms of another. The formula is:

Foreign⁢CurrencyUS⁢Currency⁢US⁢PriceForeign⁢Price

For example, if a sandwich costs $3 in the US and £1.5 in the UK, and the nominal exchange rate is 0.5 GBP/USD, the real exchange rate would be:

0.51⁢31.5=1

This means you can buy one sandwich in the US for the same amount of money as one sandwich in the UK.

What factors influence nominal exchange rates?

Several factors influence nominal exchange rates, including interest rates, inflation rates, political stability, economic performance, and market speculation. Higher interest rates in a country can attract foreign capital, leading to currency appreciation. Conversely, higher inflation rates can depreciate a currency as it loses purchasing power. Political stability and strong economic performance can boost investor confidence, leading to currency appreciation. Market speculation and trading activities also play a significant role, as traders' perceptions and actions can cause short-term fluctuations in exchange rates.

Why is understanding real exchange rates important for international trade?

Understanding real exchange rates is crucial for international trade because it provides a more accurate measure of a currency's purchasing power. While nominal exchange rates tell you how much of one currency you can get for another, real exchange rates show how much goods and services you can actually buy with that currency in different countries. This helps businesses and policymakers make informed decisions about pricing, investment, and trade policies. For example, a stronger real exchange rate means that domestic consumers can buy more foreign goods, which can affect import and export balances.