18.2 The Prices of International Transactions: Real and Nominal Exchange Rates

18.2 a. Nominal Exchange Rates

The nominal exchange rate E is defined as the number of units of the domestic currency that can purchase a unit of a given foreign currency. A decrease in this variable is termed nominal appreciation of the currency. An increase in this variable is termed nominal depreciation of the currency [12].

Example: When one changes dollars for pounds, the bank lists an exchange rate of, say, two dollars for one pound. This is the nominal exchange rate. While this indicates the number of pounds one receives for a dollar (or vice versa), it does not show the purchasing power of the pound versus that of the dollar [13].

^{Nominal Exchange Rate [14]}

18.2 b. Real Exchange Rates

The real exchange rate R is defined as the ratio of the price level abroad and the domestic price level, where the foreign price level is converted into domestic currency units via the current nominal exchange rate. Formally, R= (E.P*)/P, where the foreign price level is denoted as P* and the domestic price level as P. A decrease in R is termed appreciation of the real exchange rate, an increase is termed depreciation [12].

Example: Where a country experiences a higher rate of domestic inflation than its trade competitors, then its exports will become more expensive than those of competitors’ exports and its imports cheaper than domestic products, unless its exchange rate depreciates to offset fully the inflation differential [15].

^{Real Exchange Rate [16]}