Nominal and Real Exchange Rates

Incorrect. In this case, the nominal exchange rate has increased, making foreign goods more expensive to the US resident. In addition, the price level has grown more rapidly in Europe making prices faced by US residents even more expensive. Since both changes are moving in the same direction, the real exchange rate has unambiguously increased from the US resident’s perspective.

A __nominal exchange rate__ illustrates the amount of a particular currency that would be required to purchase one unit of another currency. For example, the USD/EUR exchange rate would compare the price of a euro (EUR) in terms of US dollars (USD). If the USD/EUR exchange rate was 1.212, then a trader would need USD 1.212 to buy one euro. With that as a background, which of the following do you think is the most reasonable interpretation if the exchange rate was USD/EUR = 0.93?

Yes. With a higher exchange rate alone, US residents can purchase 15% fewer goods and services. However, prices in Europe have increased at a rate that is 7% faster than observed in the US. The change in the nominal exchange rate, coupled with prices that have increased 7% faster in the foreign nation combine to increase the real exchange rate by 22%. Put another way, these factors have reduced the domestic residents’ purchasing power by: $$\displaystyle 15 \% + (12 \% - 5 \%) = 22 \% $$.

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Incorrect. Note that when prices rise in foreign nations at a rate faster than those observed in the domestic nation, the real exchange rate increases. If the nominal exchange rate USD/EUR increased by 5%, the price level in Europe increased by 10%, and the price level in the US increased by 7%, then the real exchange rate USD/EUR would have increased by 8%.

Correct! Since each EUR can be purchased for USD 0.93, one USD is more valuable than one EUR. Note that this exchange rate is a nominal exchange rate.

Incorrect. Think of the exchange rate as the number of units of the currency in the numerator (called the price currency) that would be needed to buy one unit of currency in the denominator (called the base currency).

Incorrect. In this case, the price currency and the base currency are being reversed.

Where a nominal exchange rate measures the rate at which two currencies can be traded, a __real exchange rate__ measures how many units of a good can be traded for one unit of that good in another country. Put another way, a real exchange rate considers the nominal exchange rate but also takes into account changes in prices. This adjustment may not seem important when engaging in foreign exchange but it does have a significant bearing on purchasing power. Given a scenario where only two countries exist, the domestic country and a foreign country, which of the following scenarios do you think describes changes in a real exchange rate?

Incorrect. In this case, the domestic consumer’s ability to purchase imports has been eroded through both depreciation of the domestic currency and increased prices levels abroad.

Incorrect. These changes work in opposite directions; an appreciating currency would improve purchasing power while a higher price level abroad would erode purchasing power. The outcome here is ambiguous.

Correct! In this case, the domestic consumer’s purchasing power is reduced given higher prices abroad. Unlike nominal exchange rates, real exchange rates are not published or quoted. However, they are routinely calculated by analysts because they provide insight to the competitiveness of an economy or the purchasing power of selected consumers. The real exchange rate between two currencies, for example the US dollar (USD) and the euro (EUR), can be calculated as $$S_{USD/EUR} \times (P_{Europe}/P_{US}) $$, where $$S_{USD/EUR}$$ is the nominal exchange rate and $$P_{Europe}$$ and $$P_{US}$$ refer to the price level in the Eurozone and the US respectively.

If prices in the US increased, which of the following would you conclude?

Incorrect. This may be more clearly seen from the perspective of the European resident. Since US prices have increased, US goods appear more expensive to the European consumer. Thus it could be said that the real exchange rate has increased from the European resident’s perspective.

That's right! As prices increase in the US, goods are more expensive for a European consumer. As such, the real exchange rate has increased for a European resident and decreased for a US resident.

Incorrect. Recall that real exchange rates consider both changes in nominal exchange rates and changes in the price level in each country. In this scenario, only a price change is being considered.

In some cases, changes in the nominal exchange rate and changes in price levels could impact the real exchange rate simultaneously. If the nominal exchange rate USD/EUR increased by 15%, the price level in Europe increased by 12%, and the price level in the US increased by 5%, what would the impact be on the real exchange rate USD/EUR?

Dollars are more valuable than euros

A dollar can be purchased for EUR 0.93

A euro would cost USD 1.075 to purchase

If the domestic currency depreciates and the price level in the foreign nation increases, then a domestic consumer could buy more imports

If the domestic currency appreciates and the price level in the foreign nation increases, then a domestic consumer could not buy as many imports over time

If the nominal exchange rate is unchanged but the price level in the foreign nation increases, then a domestic consumer could not buy as many imports

The nominal exchange rate USD/EUR has increased

The real exchange rate USD/EUR has increased from the perspective of a US resident

The real exchange rate USD/EUR has decreased from the perspective of a US resident

The real exchange rate for a US resident has decreased by 2%

The real exchange rate for a US resident has increased by 8%

The real exchange rate for a US resident has increased by 22%

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