Nominal Exchange Rates versus Real Exchange Rates
As we begin discussing exchange rates, we must
make the same distinction that we made when discussing
GDP.
Namely, how do nominal exchange rates and real exchange
rates differ?
The nominal exchange rate is the rate at which currency can
be exchanged. If the nominal exchange rate between the dollar
and the lira is 1600, then one dollar will purchase 1600
lira. Exchange rates are
always represented in terms of the amount of foreign
currency that can be purchased for one unit of domestic
currency. Thus, we determine the nominal exchange rate
by identifying the amount of foreign currency that can
be purchased for one unit of domestic currency.
The real exchange rate is a bit more complicated than the
nominal exchange rate. While the nominal exchange rate
tells how much foreign currency can be exchanged for a unit
of domestic currency, the real exchange rate tells how much
the goods and services in the domestic country can be
exchanged for the goods and services in a foreign country.
The real exchange rate is represented by the following equation:
real exchange rate = (nominal exchange rate X domestic price) /
(foreign price).
Let's say that we want to determine the real
exchange rate for wine between the US and Italy. We know
that the nominal exchange rate between these countries is
1600 lira per dollar. We also know that the price of wine
in Italy is 3000 lira and the price of wine in the US is
$6. Remember that we are attempting to
compare equivalent types of wine in this example. In this
case, we begin with the equation for the real exchange rate
of real exchange rate = (nominal exchange rate X domestic
price) / (foreign price). Substituting in the numbers from
above gives real exchange rate = (1600 X $6) / 3000 lira =
3.2 bottles of Italian wine per bottle of American wine.
By using both the nominal exchange rate and the real
exchange rate, we can deduce important information about the relative
cost of living in two countries. While
a high nominal exchange rate may create the false
impression that a unit of domestic currency will be able to
purchase many foreign goods, in reality, only a high real
exchange rate justifies this assumption.
Net Exports and the Real Exchange Rate
An important relationship exists between net exports and
the real exchange rate within a country. When the real
exchange rate is high,
the relative price of goods at home
is higher than the
relative price of goods abroad. In this case,
import is
likely because foreign goods are cheaper, in real terms,
than domestic goods. Thus, when the real exchange rate is
high, net exports decrease as imports rise. Alternatively,
when the real exchange rate is low, net exports increase as
exports rise. This relationship helps to show the effects
of changes in the real exchange rate.
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