Lesson 4 of 8 · 13 min
Nominal and real exchange rates
The real exchange rate adjusts the nominal rate for price levels at home and abroad, so it measures what your money actually buys of foreign goods: the higher it is, the lower your relative purchasing power.
In short
- Nominal exchange rates are the rates quoted and traded in the market.
- Real exchange rates are analyst-built indexes: nominal rate × foreign price level / domestic price level. They are not traded.
- With the domestic currency as the price currency, the real rate rises with the nominal rate and foreign prices and falls with domestic prices.
- A higher real rate (d/f) means foreign goods are dearer in real terms: lower domestic purchasing power.
- Approximation: % change in real rate ≈ % change in nominal rate + foreign inflation − domestic inflation.
- Purchasing power parity would equalise real prices across countries, but deviations are large and persistent, so real rates forecast nominal rates poorly.
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