The Difference between the Nominal Exchange Rate and the Real Exchange Rate

The exchange rate of a currency is the rate at which the currency can be exchanged for another currency. It is also defined as the price of the currency in terms of another currency. This is known as the nominal exchange rate. For instance, the nominal exchange rate of the Singapore dollar against the Malaysian ringgit is about RM2.50/S$ which means that 2.5 Malaysian ringgits are required to exchange for or purchase 1 Singapore dollar. It is important to note that the exchange rate of a currency is expressed as the amount of foreign currency that is required to purchase one unit of the currency.

Unlike the nominal exchange rate of a currency which refers to the amount of foreign currency that is required to exchange for or purchase one unit of the currency, the real exchange rate of a currency refers to the amount of foreign goods and services that is required to exchange for or purchase one unit of domestic goods and services. Mathematically, it can be expressed as

                                     Nominal Exchange Rate x Domestic Price Level

Real Exchange Rate = ————————————————————————-

                                     Foreign Price Level

To illustrate the real exchange rate of the Singapore dollar against the Malaysian ringgits, assume that apple is the only good in Malaysia and Singapore. Further assume that an apple costs RM2 in Malaysia and S$4 in Singapore.

Using the above equation,

                               RM2.5/S$ x S$4

Real Exchange Rate = ——————————— = 5

                                 RM2

This means that 5 apples in Malaysia are required to exchange for or purchase 1 apple in Singapore.

The real exchange rate is more useful than the nominal exchange rate in the sense that the former takes into account the relative prices of goods and services in the two countries. Therefore, the real exchange rate is a better indicator of net exports. When the real exchange rate falls, net exports will rise, other things being equal. The converse is also true.

A more elaborate explanation will be provided in economics tuition at Economics Cafe.

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