Distinguish
between the nominal exchange rate and the real exchange rate. If you
were to decide whether to buy domestic goods or foreign goods, which
rate would be more relevant? Explain.
Distinguish between the nominal exchange rate and the real exchange rate. If you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.
Nominal
exchange rate is the price of one currency in terms
of another. It is the amount of domestic currency required to buy one
unit of foreign currency. For example a rupee-dollar exchange rate of
Rs 45 means that it costs 45 rupees to buy 1 dollar.
Real
exchange rate is the ratio of foreign prices to domestic prices. In
other words, it measures foreign prices relative to domestic prices.
Real
exchange rate
Where Pf
− price level of foreign currency
P −
Price level of domestic currency
e −
Nominal exchange rate
For
example, if a watch costs $40 in US and the nominal exchange rate is
Rs
50 per US dollar, then, with real exchange rate of 1, it should cost
Rs 2,000 (ePf = 50 × 40 = Rs
2000) in India.
If, I were
to decide whether to buy domestic goods or foreign goods, then real
exchange rate will be more relevant, because real exchange rate takes
the inflation differential among the countries into account and is
also used as an indicator of a country’s competitiveness
in the foreign trade.
Nominal exchange rate is the price of one currency in terms of another. It is the amount of domestic currency required to buy one unit of foreign currency. For example a rupee-dollar exchange rate of Rs 45 means that it costs 45 rupees to buy 1 dollar.
Real exchange rate is the ratio of foreign prices to domestic prices. In other words, it measures foreign prices relative to domestic prices.
Real
exchange rate
Where Pf − price level of foreign currency
P − Price level of domestic currency
e − Nominal exchange rate
For example, if a watch costs $40 in US and the nominal exchange rate is Rs 50 per US dollar, then, with real exchange rate of 1, it should cost Rs 2,000 (ePf = 50 × 40 = Rs 2000) in India.
If, I were to decide whether to buy domestic goods or foreign goods, then real exchange rate will be more relevant, because real exchange rate takes the inflation differential among the countries into account and is also used as an indicator of a country’s competitiveness in the foreign trade.
