Distinguish between the nominal exchange rate and the real exchange rate. If you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.
Nominal exchange rate is the price of foreign currency in relation to domestic currency. Suppose we say 1 USD equals to 66 INR it means 66 Indian rupees are required to buy one US dollar and this is nominal exchange rate
Real exchange rate is the price of foreign goods in terms of domestic goods. Now suppose we are buying 1 kg of potato for 2 US dollars and converting it into Indian rupees it will be 2 X 66, whereas the price of potatoes in India is Rs 10 per kg, this will be the real exchange rate.
Real Exchange Rate = e (Pf / P)
Where –
e = Nominal Exchange Rate
Pf =Price level of foreign currency
P = Price level of domestic currency
For given example of potatoes the real exchange rate will be –
= 66 (2 / 10)
= 13.2
It means you can buy 13.2 kgs of potatoes in India for the price that you will pay in buying them in US. The real exchange rate is important for tourists going abroad.
If I decide to buy domestic goods or foreign goods the real exchange rate will be more relevant than the nominal exchange rate.