The most foundational concept for currency exchange rates are nominal and real exchange rates as well as nominal effective exchange rate and real effective exchange rates.The classification is being done with consideration of the Inflation. The Nominal Exchange Rate a measurement of one national currency by another national currency, for example EUR/USD=1.1. We write in the following way:
– is the nominal exchange rate.
– is the currency of country “A”.
– is the currency in country “B”.
The nominal exchange rate is used for current transactions, however it’s not convenient for perspective calculations as exchange rate changes with time in parallel with an Inflation. Accounting the Inflation rate in the countries, we can calculate the Real Exchange Rate, in the fallowing way:
– is the Real Exchange Rate.
Looking at the formula of Real Exchange Rate we can see that if in country “A” the inflation rate is higher than in country “B”, the Real Exchange Rate will be higher than the Nominal Exchange Rate, and vice versa.
For example: according to ECB, in the January 2016 the average nominal exchange rate of EUR/USD was 1.0859 while the the inflation rate in Euro Area in the same time frame was 0.7% and according to Fed, the CPI (consumer price index) was 0 in the January 2016. So, if the nominal exchange rate was 1.0859 then accounting the CPI the real exchange rate was 1.0784. How we got 1.0784 and how to calculate the real exchange rate? The logic is the following: if the exchange rate of EUR/USD was 1.0859 (what means that for 1 EUR we need to pay 1.0859 USD) and the prices in Euro Area increased for 0.7% then for the basket of goods and services which cost was 1 EUR, we had to pay 1.007 EUR. The prices in US remained the same, so for a basket of goods and services with a cost of 1.0859 we still had to pay the same price. So, 1.0859/1.007~1.0784.
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