Nominal and real exchange rates

• The nominal exchange rate e is the price in domestic currency

of one unit of a foreign currency.


• The real exchange rate (RER) is defined as , where P is the

domestic price level and P * the foreign price level. P and P * must have

the same arbitrary value in some chosen base year. Hence in the base

year, RER = e.


The RER is only a theoretical ideal. In practice, there are many foreign

currencies and price level values to take into consideration.

Correspondingly, the model calculations become increasingly more

complex. Furthermore, the model is based on purchasing Power Parity

(PPP), which implies a constant RER. The empirical determination of a

constant RER value could never be realised, due to limitations on data

collection. PPP would imply that the RER is the rate at which an

organization can trade goods and services of one economy (e.g. country)

for those of another. For example, if the price of a good increases 10% in

the UK, and the Japanese currency simultaneously appreciates 10%

against the UK currency, then the price of the good remains constant for

someone in Japan. The people in the UK, however, would still have to

deal with the 10% increase in domestic prices. It is also worth mentioning

that government-enacted tariffs can affect the actual rate of exchange,

helping to reduce price pressures. PPP appears to hold only in the long

term (3–5 years) when prices eventually correct towards parity.
More recent approaches in modelling the RER employ a set of

macroeconomic variables, such as relative productivity and the real

interest rate differential.