What is the nominal and real exchange rate?
The nominal exchange rate E is defined as the number of units of the domestic currency that can purchase a unit of a given foreign currency. A decrease in this variable is termed nominal appreciation of the currency. (Under the fixed exchange rate regime, a downward adjustment of the rate E is termed revaluation.) An increase in this variable is termed nominal depreciation of the currency. (Under the fixed exchange rate regime, an upward adjustment of the rate E is called devaluation.)
By contrast, the real exchange rate R is defined as the ratio of the price level abroad and the domestic price level, where the foreign price level is converted into domestic currency units via the current nominal exchange rate. Formally, R=(E.P*)/P, where the foreign price level is denoted as P* and the domestic price level as P. A decrease in R is termed appreciation of the real exchange rate, an increase is termed depreciation. The real rate tells us how many times more or less goods and services can be purchased abroad (after conversion into a foreign currency) than in the domestic market for a given amount. In practice, changes of the real exchange rate rather than its absolute level are important. In contrast to the nominal exchange rate, the real exchange rate is always ”floating”, since even in the regime of a fixed nominal exchange rate E, the real exchange rate R can move via price-level changes.
Rather than focusing on the nominal exchange rate, it is more sensible to monitor the real exchange rate when assessing the effect of exchange rates on international trade or export competitiveness of a country. For simplicity, assume that the domestic price level rises by 10%, the foreign price level remains unchanged and the domestic currency depreciates nominally by 10%. Then the real exchange rate, i.e. the ratio of prices at home and abroad, remains unaffected, depreciation of the domestic currency notwithstanding. Other things held equal in our simplified framework, there would be no change in the demand for imports in the domestic economy and in the demand for exports of the domestic economy abroad.