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.
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Nominal exchange rate: It is price of foreign currency in terms of domestic currency.
When cost of purchasing one unit of foreign currency (say, dollar) is quoted in terms of domestic currency (say, rupees), it is called nominal exchange rate because exchange rate is quoted in money terms i.e. so many rupees per dollar. For instance if 1 American dollar can be obtained for 50 indian rupees i.e. if it costs 50 to buy 1 dollar, it will be called nominal exchange rate.
Real exchange rate: It is relative price of foreign goods in terms of domestic goods. When cost of purchasing one unit of domestic currency (say, rupees) is quoted in terms of foreign currency (say, dollar), it is called real exchange rate. For instance in the above case it costs 2 cents (1 dollar=100 cents) to buy 1 rupee. People who plan to visit America need to know how expensive American goods are relative to goods at home.
Real exchange rate = e(Pf/P)
Where Pf - price level of foreign currency
P - Price level of domestic currency
e - Nominal exchange rate
For example, if a watch costs $40 in US and the nominal exchange rate is 50 per US dollar, then, with real exchange rate of 1, it should cost Rs 2,000 ( ePf= 50 x 40 = Rs 2000) in India.
If, I was to decide whether to buy domestic goods or foreign goods, then real exchange rate will be more relevant, because real exchange rate takes the inflation differential among the countries into account and is also used as an indicator of a country's competitiveness in the foreign trade.
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