Economics Exchange Rates Questions Medium
The nominal exchange rate refers to the rate at which one currency can be exchanged for another currency. It is the value of one currency in terms of another currency. For example, if the nominal exchange rate between the US dollar and the euro is 1.2, it means that one US dollar can be exchanged for 1.2 euros.
On the other hand, the real exchange rate takes into account the relative purchasing power of two currencies. It is the ratio of the prices of a basket of goods and services in two different countries. The real exchange rate reflects the actual purchasing power of a currency in terms of another currency.
To calculate the real exchange rate, the nominal exchange rate is adjusted for inflation. This adjustment accounts for the changes in the price levels between two countries. If the real exchange rate is higher than the nominal exchange rate, it means that the domestic currency is overvalued, and if it is lower, it means that the domestic currency is undervalued.
In summary, the main difference between nominal and real exchange rates is that the nominal exchange rate only considers the value of one currency in terms of another currency, while the real exchange rate takes into account the purchasing power of the currencies by adjusting for inflation.