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By the end of these notes, you should be able to:
An exchange rate is simply the price of one country's currency expressed in terms of another country's currency.
For example, if the exchange rate between the British pound and the US dollar is 1 pound = 1.25 dollars, then to buy 1 British pound, you need to hand over 1.25 US dollars.
Exchange rates matter because every time a country imports or exports goods, the currencies of both countries are involved. A change in the exchange rate affects how expensive a country's goods are to foreign buyers, and how expensive foreign goods are to domestic buyers.
The nominal exchange rate is the actual, face-value price of one currency in terms of another. It is the number you see quoted at a bank or an airport currency exchange.
So the nominal exchange rate tells you the raw number, but it doesn't tell you how much purchasing power (buying power) you actually have.
The real exchange rate adjusts the nominal exchange rate to account for differences in price levels (the general level of prices) between two countries.
In simple terms: the real exchange rate tells you how many goods and services in one country you can exchange for goods and services in another country.
Formula:
Real Exchange Rate = Nominal Exchange Rate × (Domestic Price Level ÷ Foreign Price Level)
Why does it matter?
Imagine the nominal exchange rate stays the same between Country A and Country B, but prices in Country A rise much faster than in Country B. Country A's goods become more expensive in real terms, even though the exchange rate number hasn't changed. The real exchange rate captures this.
Key Distinction:
| Nominal Exchange Rate | Real Exchange Rate | |
|---|---|---|
| What it shows | The face-value price of one currency in another | The adjusted rate accounting for price level differences |
| Accounts for inflation? | No | Yes |
| Used for | Day-to-day currency transactions | Comparing international competitiveness |
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