The essay is an in-depth examination of two major economic terms; real exchange rate and nominal exchange rate. It is no doubt that these terms are more often than not used in economy. Unfortunately, it does not only confuse non economist but also some of the economics students (O’Sullivan & Sheffrin 24).
The paper thus seeks to clearly distinguish the two terms and succinctly explain the reasons behind real exchange rate being used rather than nominal exchange rates.
It is worth mentioning here that exchange rate is of great significance in economics since it expresses a country’s currency quotation as compared to foreign currencies (Munro 41). It helps in specifying how much a currency of one country is worth compared to another.
For that matter it is used in converting currencies. There are different types of exchange rate; sport, forward, bilateral, pegged real and nominal the last two are the center of discussion.
Differences between real exchange rate and nominal exchange rate
Nominal exchange rate has been economically defined as the actual foreign exchange quotation which is the opposite of real exchange rate that has been adequately adjusted to cater for changes in the purchasing power of a country currency. Mathematically, nominal exchange rate is considered in terms of prices of domestic currency of a unit of currencies from other foreign countries.
It is worth noting that the determinants of nominal exchange rate are; changes in real side of economy, variability in monetary as well as financial attributes usually influenced by what has been termed as cross link market and finally past as well as current values of same financial markets with it independent variability (Smith par. 3).
Additionally, nominal exchange rates are brought to play in financial markets. In that case they are more less the same as stock exchange market. It is worth noting that the establishment of the rate is done on a continuous quotation. Print media especially newspaper on daily basis report such quotations. There are also cases where the central bank might engage in fixing such type of rate (Sanderson 31).
On the other hand, real exchange rate has been thought of as a corrected nominal rate probably by considering issues relating to inflation. Strictly speaking, real exchange rate is different from nominal exchange rate as the former factors in issues of goods that are either tradable or non-tradable.
With this in mind, when prices go up and other things remain constant, and then real exchange rate appreciates (O’Sullivan & Sheffrin 345). Additionally, real exchange rate tells us more about the differences in prices by weighting trade volumes. Similarly, it shows what a country really gets for one unit of her domestic currency.
Reasons why real exchange rate is utilize
According to Gillmore par. 5 the major reason for utilizing real exchange rate over nominal exchange rate solemnly lies on the concept that the former is a corrected version of the later.
This means that the varying level of inflation rates in various countries as compared to that of a given country is adequately factored in (Sanderson 19). For that reason, this provides the relevant stakeholders with a more specific and informative value of their currency. This is very important considering doing business internationally (Engel 45).
From the review of the two economic terms, nominal and real exchange rate, there are indeed some distinguishing characteristics such as real exchange rate factors in issue relating to inflation rates while nominal does not.
Similarly real exchange rate is utilize rather than nominal exchange rate since it provide individuals and government with informative information concerning the country’s currency strength as it considers inflation rates from different countries.
Engel, Charles. Exchange rates and prices, 1998. Web.
Gillmore, David. The costs of inflation, 2008. Web.
Munro, Anella. What drives the New Zealand dollar? 2004. Web.
O’Sullivan, Arthur & Sheffrin, Steven. (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall, 2003. Print. pp. 458.
Sanderson, Raymond. Exchange rates and export performance: evidence from the micro data 2009. Web.
Smith, Mark. Impact of the exchange rate on export volumes, 2004. Web.