NOMINAL VERSUS REAL EXCHANGE RATES

NOMINAL VERSUS REAL EXCHANGE RATES

• We have been discussing so far about nominal exchange rate which simply states how much of one currency (i.e. money) can be traded for a unit of another currency when prices are constant. When prices of goods and services change in either or both countries, it would be difficult to know the change in relative prices of foreign goods and services.
•  Therefore, Real Exchange Rate (RER) which incorporates changes in prices is a better measure. The ‘real exchange rate' describes ‘how many’ of a good or service in one country can be traded for ‘one’ of that good or service in a foreign country. It is calculated as :

             Real exchange rate = Nominal exchange rate X domestic price index/foreign price index

Another exchange rate concept, the Real Effective Exchange Rate (REER) is the nominal effective exchange rate (a measure of the value of a domestic currency against a weighted average of variouis foreign currencies) divided by a price deflator or index of costs. An increase in REER implies that exports become more expensive and imports become cheaper; therefore, an increase in REER indicates a loss in trade competitiveness.