real exchange rate and nominal exchange rate
Nominal and real exchange rates are also important for countries to compare levels of costs of living. The exchange rate is $1 = INR60. If a foreign country (the USA) has a higher (lower) rate of inflation than UK (the home country) a pound will buy a larger (smaller) amount of a foreign currency (dollar) over time. The converse is also true. In exchange rate, the words real exchange rate and nominal exchange rate are used while doing transactions in the international market. A high nominal exchange rate may show the local currency can purchase more foreign goods and services. The real exchange rate (RER) refers to the relative price of goods of Britain and USA. Exchange rate means the rate at which one currency will be exchanged for another. The RER is just a relative price. Nominal exchange rates are the rates that you find displayed at banks and money changers, and the rate at which you can exchange foreign currency for local currency or vice versa. The nominal exchange rate (NER) is the relative price of currencies of two countries. Let’s assume the price of 1kg of rice in India as 80 INR, and the price of 1kg of rice (of equivalent quality) in US as $4.
6.5. For example, if the exchange rate is £ 1 = $ 2, then a British can exchange one pound for two dollars in the world market. A high (low) RER implies that foreign goods are relatively cheap (expensive) and domestic goods are relatively expensive (cheap). Real exchange rates may be more useful when assessing the impact of exchange rates on international trade than nominal exchange rates as it shows how many times an item of goods can be bought abroad.• Nominal exchange rates are the rates at which the currency is exchanged for. Nominal exchange rate and real exchange rate show the rate at which one currency can be purchased for another. Given the value of RER, if the domestic price level P rises, then the RER will fall. Real exchange rates are a bit more complicated and show how many times an item of goods purchased locally can be purchased abroad.
When we refer to the “exchange rate” between two countries, we usually mean the NER. Nominal exchange rates are the rates that are displayed at banks and money changers. Nominal exchange rates are the rates that are displayed at banks and money changers. Thus, percentage change in NER between pound and dollar equals the percentage change in RER plus the difference in rates of inflation in the two countries. Therefore, they are essential determinants for international trade. The Quantity Theory of Money, studied in chapter 4, suggests that a certain percentage increase in money supply will lead to proportionate increase in the aggregate price level.
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