What is the difference between nominal and real exchange rates?

Nominal exchange rates represent the value of one currency against another, while real exchange rates adjust this value for inflation.

Nominal exchange rates are the rates at which you can exchange one currency for another. For example, if the nominal exchange rate between the British pound and the US dollar is 1.3, this means you can exchange 1 pound for 1.3 dollars. Nominal exchange rates are the rates you see quoted in the foreign exchange market and are used in most international financial transactions.

On the other hand, real exchange rates take into account the relative purchasing power of the two currencies. They adjust the nominal exchange rate for differences in price levels or inflation rates between the two countries. This is important because inflation can erode the value of money over time. If prices are rising faster in one country than another, the real value of its currency will fall, even if the nominal exchange rate remains unchanged.

For example, let's say the nominal exchange rate between the pound and the dollar is still 1.3, but prices are rising faster in the UK than in the US. This means that a pound buys less in the UK than it used to, so its real value has fallen. The real exchange rate would reflect this by being lower than the nominal rate.

Understanding the difference between nominal and real exchange rates is crucial for international trade and investment. Nominal rates tell you how much of one currency you can get for another, but real rates tell you how much you can actually buy with that currency in another country. If the real exchange rate is high, it means your currency has a lot of purchasing power abroad, which can make foreign goods and investments seem cheap. Conversely, if the real exchange rate is low, foreign goods and investments can seem expensive.

IB Economics Tutor Summary: Nominal exchange rates show how much one currency can be exchanged for another, like changing pounds to dollars at a set rate. Real exchange rates, however, adjust for inflation, showing how much you can actually buy in another country with your money. While nominal rates give you the exchange numbers, real rates tell you about the purchasing power of your currency abroad.