Difference Between Nominal and Real Exchange Rate
The difference between the nominal and real exchange rates is that the former does not take into account the price level and the latter does.
To see the difference between the nominal and real exchange rate, we are going to see the definition of each one:
- Nominal exchange rate: The nominal exchange rate is the price of one currency against another in the financial markets.
- Real exchange rate: The real exchange rate is the purchasing power of our currency abroad.
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Difference between nominal and real
To see the difference between the nominal and real exchange rates , we are going to see how to go from one magnitude to another. In addition, we will explain it with examples.
Switch from nominal exchange rate to real exchange rate
To go from the nominal exchange rate to the real exchange rate , we only need to apply the following formula:
Where each unknown means:
TCR: It is the real exchange rate.
TCN: It is the nominal exchange rate.
Pe: Price level in the foreign country.
Pn: Price level in the national country.
Example of nominal exchange rate to real exchange rate
We have a nominal exchange rate of 30 pesos per dollar. The price index in the foreign country is 300 dollars. In the national country the price index is 6000 pesos.
To buy in a foreign country what is bought there with a dollar, we need 1.5 times more pesos. If in the foreign country the price of coffee is one dollar and we have pesos, we will have to pay 1.5 times more than the equivalent in pesos. That is, 45 pesos. Or in other words, to obtain 2 cups of coffee in country A, we must offer 3 national cups of coffee.
Switch from real exchange rate to nominal exchange rate
Let's go with the opposite operation. Now our goal is, from the real exchange rate , to obtain the nominal exchange rate . Mathematically it is a very simple process. All we have to do is clear the equation. Here is the mathematical development:
Example real exchange rate to nominal exchange rate
To illustrate it more easily, we will continue with the previous example. We have a real exchange rate (RER) of 1.5, foreign prices (Pe) are 300 dollars and domestic prices (Pn) are 6,000 pesos.
As we can see, if we take the same data, the nominal exchange rate (TCN) is the same. All we have done is clear up the unknowns.
With these two examples, we hope that the difference between nominal and real exchange rates has become clear .