Economics – Exchange rates | e-Consult

Nominal exchange rate is the price of one currency expressed in terms of another. For example, if it costs £1.50 to buy $1.00, the nominal exchange rate is 1.50 pounds per dollar. It's a simple measure of currency value.

Real exchange rate adjusts the nominal exchange rate for the relative price levels between two countries. It reflects the relative purchasing power of currencies. A higher real exchange rate indicates that a country's goods and services are relatively more expensive compared to another country's.

Why both are important:

• International Trade: The nominal exchange rate affects the price of exports and imports. A weaker domestic currency (lower nominal exchange rate) makes exports cheaper and imports more expensive, potentially improving the trade balance. However, the real exchange rate provides a more accurate picture of competitiveness.
• International Investment: Investors consider the real exchange rate when deciding where to invest. A high real exchange rate can discourage investment in a country because it makes domestic goods relatively more expensive and foreign goods relatively cheaper. This can impact capital flows.
• Inflation and Competitiveness: Changes in the real exchange rate can signal changes in relative price levels and therefore competitiveness. A persistently high real exchange rate might indicate inflationary pressures.

In summary, while the nominal exchange rate is easy to observe, the real exchange rate provides a more insightful measure of a country's relative economic performance and competitiveness in the global economy.