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Question

Distinguish between the nominal exchange rate and the real exchange rate. lf you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.

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Solution

Nominal Exchange Rate: It refers to the price of foreign currency in terms of domestic currency. It shows the number of units of domestic currency one must give up to get a unit of foreign currency.

Real Exchange Rate: It refers to the relative price of foreign goods in terms of domestic goods.

In order to make a purchase, one should ideally consider the real exchange rate. Real exchange rate accounts for inflation and international competitiveness and will compare the prices of the 2 goods.


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