The nominal exchange rate and the real exchange rate
Exchange rates are always represented in terms of the amount of foreign currency that can be
purchased for one unit of domestic currency. It is customary to distinguish nominal exchange
rates from real exchange rates. The nominal exchange rate is the rate at which currency can
be exchanged. Therefore the nominal exchange rate means that how much foreign currency
can be exchanged for a unit of domestic currency.
Nominal exchange rates are established on currency financial markets called
"Forex Markets", which are similar to stock exchange markets. Rates are usually established
in continuous quotation, with newspaper reporting daily quotation as average or finishing
quotation in the trade day on a specific market. Central bank may also fix the nominal
But the real exchange rate is a bit more complicated than the nominal exchange rate. The real
exchange rate tells how much the goods and services in the domestic country can be
exchanged for the goods and services in a foreign country. The real exchange rate means the
level of the exchange rate takes account of inflation differences. A way of measuring the
price of foreign goods not just in currency adjusted terms but also in price-level adjusted
terms. The real exchange rate is represented by the following equation,
Real exchange rate = (Nominal Exchange Rate * Domestic Price) / (Foreign Price).
Real exchange rates are nominal rate corrected somehow by inflation measures. For instance,
if a country A has an inflation rate of 10%, country B an inflation of 5%, and no changes in
the nominal exchange rate took place, then country A has now a currency whose real value is
10%-5%=5% higher than before. In fact, higher prices mean an appreciation of the real
exchange rate, other things equal.
The real exchange rate is the critical variable in determining the capital account. This is
because the real exchange rate is the relative price of goods across countries. Hence, changes
in the real exchange rate affect the competitiveness of traded goods. The real exchange rate
measures the cost of foreign goods relative to domestic goods. It gives a measure of
competitiveness, and it is a useful variable for explaining trade behavior and national income.
Also the real exchange rate is not only volatile; it does not appear to move around some
An important relationship exists between the real exchange rate and net exports within a
country. When the real exchange rate is high, the relative price of goods at home is higher
than the relative price of goods abroad. In this case, import is likely because foreign goods
are cheaper, in real terms, than domestic goods. Thus, when the real exchange rate is high,
net exports decrease as imports rise. Alternatively, when the real exchange rate is low, net
exports increase as exports rise. This relationship helps to show the effects of changes in the
real exchange rate.
Both the nominal exchange rate & the real exchange rate can deduce important information
about the relative cost of living in two countries. When a high nominal exchange rate may
create the false impression that a unit of domestic currency will be able to purchase many
foreign goods, in reality, only a high real exchange rate justifies this assumption.
The purchasing power parity theory
Purchasing power parity (PPP) theory is an economic theory and a technique used to
determine the relative value of currencies, estimating the amount of adjustment needed on
the exchange rate between countries in order for the exchange to be equivalent to each
currency's purchasing power. It asks how much money would be needed to purchase the
same goods and services in two countries, and uses that to calculate an implicit foreign
Also this theory identifies how the differences in inflation rates between countries would lead
to changes in the exchange rates. Also it facilitates international comparisons of income, as
market exchange rates are often volatile, are affected by political and financial factors that do
not lead to immediate changes in income.
The Purchasing power parity rate is calculated by the following equation.
Future Rate (A/B) = Spot Rate (A/B) * (1 + Inflation Rate A) / (1 + Inflation Rate B).
For an example the current spot rate between US & UK is set at USD 1.5 per Pound. The US
inflation rate is 6% & UK inflation rate is 4%. So the future exchange rate is calculated by
below mentioned method.
Future Exchange Rate = USD 1.5 per Pound * (1+0.06) / (1+0.04) = USD 1.528 per Pound.
The explanation of above example is because of the USD would be having a higher inflation
rate. So it loses its purchasing power more than Pound. Therefore more USD would require
than the current amount to buying one Pound in future. Therefore the USD depreciated.
Factors that influence the supply and demand for a country’s good & its
Below mentioned factors are the short term factors that influence the supply and demand for
a country’s good & its exchange rate.
The first factor is the trade flows of the country. It means that the monthly import and export
level will have an impact on the exchange rate. In a given month if a country has more
demand for imports and less demand for exports, the currency will depreciate because there is
bigger demand for foreign currency. On the other hand, if the country has more demand for
exports and less demand for imports since there would be a higher demand for the domestic
currency. So the domestic currency will appreciate.
The second factor is the investment flows of the country. If a country is receiving more
foreign investment, there would be a higher demand for a domestic currency. Therefore the
domestic currency would appreciate. However, if a country does more investment to outside
countries, then there would be a higher demand for foreign currency. So the domestic
currency will depreciate.
The third factor is the economic prospectus of the country. This is where the level of
economic progress of a country would have an impact on the exchange rate of that country. If
a country has good economic policies and it is showing shines of growth, it could receive
more investment as well as the demand for country’s products from foreign markets which
increased their supply of goods. Therefore the domestic currency of that country would
appreciate. However if the economic prospectus are bleak, then there would be lesser
investment as well as no or low demand for their products in that country. Therefore the
domestic currency of that country would depreciate.
Below mentioned factors are the long term factors that influence the supply and demand for a
country’s good & its exchange rate.
The first factor is the interest rate parity theory. This theory links the future currency rates
with differences in interest rate between countries. The Purchasing power parity rate is
calculated by the following equation.
Future Rate (A/B) = Spot Rate (A/B) * (1 + Interest Rate A) / (1 + Interest Rate B).
If the country has a higher interest rate, they would indeed attract more foreign investment
but have less demand & supply of their products. In the short term this would lead to an
appreciation of domestic currency. However in the long term, this would create a situation
where the received amount of foreign currency through that more foreign currency being sent
to the country due to interest payment. Therefore the domestic currency would depreciate.
The second factor is the monetarist theory, which identifies the relationship between the
government money supply to an economy and its exchange rates. Through various
developments of projects, when government releases more money to an economy, individual
would have more money in hand and therefore they purchase more. Therefore the increased
demand of the goods & services and suppliers are supply more which results in higher prices
and also create inflation. So this would lead to a high level of depreciation to the currency.
The third factor that influence the supply and demand for a country’s good & its exchange
rate in long term is the purchasing power parity theory that mentioned in the second part of
The last factor is the Keynesian approach that says that an exchange rate may not
appreciating and depreciating in a balance and that sometimes currency may continuously
appreciate or depreciate without reverse. If there is high demand for imported items in a
country than their goods and the demand is price inelastic. Also the exports of that country
are losing its position to exports of other country which means the demand for their products
is low, and also due to the heavy competition, there is a high level of price elasticity in the
demand. Therefore without any appreciation, the domestic currency of that country will
continuously depreciate over a long time period.