Nominal and Real Exchange Rates

Updated Dec 28, 2022

Exchange rates define the value of a currency in relation to other currencies. Therefore, they are essential determinants for international trade. After all, exchange rates have a significant impact on how cheap or expensive foreign goods or services are, relative to domestic prices. Starting from there, we can measure two types of exchange rates: nominal and real exchange rates (see also classical dichotomy). We will look at the meaning and purpose of this distinction in more detail below.

1. Nominal Exchange Rates

The nominal exchange rate describes the rate at which an individual can trade the currency of one country for the currency of another country. That means it measures how much of currency B can be bought in exchange for currency A or vice versa. Starting from there, all exchange rates can be expressed in two different ways, depending on the base currency we chose. That means we can either measure how much of currency B we get in exchange for currency A or measure how much of currency A we receive in exchange for currency B. 

To illustrate this, let’s say you go to a bank to exchange USD 100 to EUR. The bank offers you EUR 0.88 per USD, i.e., USD 1.00 is worth EUR 0.88 at this time. That means you can get EUR 88 in exchange for USD 100 (i.e., 100 x 0.88). Of course, you can always change your EUR 88 back to USD if you want. In that case, the bank offers you USD 1.14 per EUR. Note that the exchange rate looks different because it uses the EUR as the base currency instead of USD. However, it’s pretty much the same thing (if we ignore the rounding error). So, with this exchange rate, you can get your initial USD 100 back, in exchange for EUR 88 (i.e., 88 x 1.14).

However, please note that the bank won’t actually use the exact same exchange rate for buying and selling a currency. It will charge slightly different prices, which is how it generates profits from offering exchange services.

2. Real Exchange Rates

The real exchange rate describes the rate at which an individual can trade the goods and services of one country for the goods and services of another country. That means it describes how much of a foreign good or service can be exchanged for one unit of a domestic product. The real exchange rate is closely related to the nominal exchange rate because the prices of the relevant goods and services must always be converted to the same currency before they can be compared. Therefore, we can use the following formula to calculate the real exchange rate:

Real Exchange Rate = (Nominal Exchange Rate x Domestic Price) / Foreign Price

To give an example. Assume you are looking for a good place to spend your next vacation. You find two hotels online, one in Ibiza (Spain) and another one in Hawaii (USA). The price of a room in Ibiza is listed at EUR 65 per night. Meanwhile, a night in a hotel room in Hawaii costs USD 150. As we know from our example above, the nominal exchange rate between USD and EUR is 0.88 EUR per USD. Now, if we plug this into the formula above, we find that the real exchange rate between the two hotel rooms is 2.03 nights in Ibiza per night in Hawaii (i.e., 0.88 x 150 / 65). In other words, you could spend more than twice as many nights in Ibiza than in Hawaii for the same amount of money.

Please note that in practice, the real exchange rate is usually calculated using price indices (e.g., consumer price index) as opposed to individual products. That means it measures the price of a basket of goods available domestically relative to a basket of goods available in a foreign country. This makes it an essential determinant of a country’s net exports because a fall (i.e., depreciation) in the real exchange rate makes that country’s products more attractive to buyers from other countries (i.e., because they become relatively cheaper) and vice versa.

Summary

Exchange rates define the value of a currency in relation to other currencies. We can measure two types of exchange rates: nominal and real exchange rates. The nominal exchange rate describes the rate at which an individual can trade the currency of one country for the currency of another country. By contrast, the real exchange rate describes the rate at which an individual can trade the goods and services of one country for the goods and services of another country.