For every nominal exchange rate, there’s a real exchange rate.
The nominal exchange rate is how much of one currency you can get for another. For one U.S. dollar, you could get 65.10 Russian Rubles, 7.84 Hong Kong dollars, or 1.43 Australian dollars. This is what you want to know when you’re standing at a currency exchange counter, or you’re at an ATM in a foreign country. Fair enough.
The real exchange rate is how much goods and services in your country can be exchanged for goods and services in the foreign country. Yep, a bit more complicated.
[Real exchange rate] = [nominal exchange rate] x [domestic prices] / [foreign prices]
Let’s take the cost of a pineapple bun in Hong Kong. Say it’s $5 Hong Kong dollars. In the U.S., you can get a pineapple bun for $2 (if you can find it). If the exchange rate is 1:7.84, then here’s our real exchange rate:
$7.84 HKD x $2 USD / $5 = about 3.14 pineapple buns
That means you can get 3.14 pineapple buns in Hong Kong for every 1 pineapple bun in the U.S.
Rather than calculating the real exchange rate for every single good, economists are more likely to use price indexes, i.e. baskets of goods, to get a macroeconomic real exchange rate.
Related or Semi-related Video
Finance: What is an Exchange Rate?358 Views
Finance a la shmoop what is an ex change rate? alright I give you two cleary's for
one cat eye you give me to come quat's for one banana with the peel on this [Person trades come quats for banana]
time thank you I give you forty two thousand three
hundred eighty two dollars for this new Ford Hemi truck with the awooga horn yep
these are all exchange rates marbles for marbles fruit for fruit and well dollars
for trucks with awooga horns in place just do what you know... people off well in
more common financee parlance exchange rates focus on the trading back and
forth of national currencies while each country or region generally has its own [Selection of currencies appear and man holding an Uzi]
currency printing more of that currency lets the government pay its bills more
easily if it's not collecting enough dough in taxes but if it prints too much
of that currency well then it falls in value relative to the currencies of
other countries think about that you print lots of dollars and you have lots
of debt well then it's easy to pay back your debt right but if you do that too [Money transfers into debt]
long people don't trust your currency and then it creates all kinds of havoc
when you want to trade with them well when all that happens and it's volatile
currencies back and forth the goods of the inflated country seem cheap to other
countries and in theory well then they buy more stuff from the country that's [Other countries trading from inflated country]
got cheap currency and it makes it much more expensive for the inflated currency
country to then buy more from the we don't print too much currency country
one euro cost about two US dollars when it first came out in the early 90s a
nice hotel that was 250 a night in Paris cost a US currency holder about 500
bucks right like it was 250 euros it was 500 US dollars pay for that same hotel
so you can imagine there were not a whole lot of US tourists anxious to rent
Hotel nights from Rue de la blah blah blah but when Europeans looked at buying [eBay website appears]
american-made speedo swimsuits oh yeah they were cheap and clearly too many
Europeans bought them but then the euro fell into closer parity with the US
dollar in part because faith in their economic union fell and because the US
appeared to be printing money at a slower pace than worthy Europeans and
the public kind of wanted US dollars instead of euros because they thought
the US a little bit more secure so what happened well the relative
inflation of the US was in better shape than that of Europe
so today the exchange rate after a long time decades is now about one to one [Man discussing exchange rates]
meaning one US dollar buys you about one euro and same vice versa yeah so
you'd say that the rate of euros to dollars is about even and coincidentally
a US dollar buys you about 100 new Japanese yen and a US dollar buys about
600,000 Zimbabwean dollars and let's see US dollar also buys fourteen thousand
galleons if you know you're vacationing at Hogwarts lovely time [Hogwarts castle appears]
Up Next
How does foreign exchange work? As the largest market in the world, foreign exchange is a 24/7 affair. It is the buying and selling of one nationâ€...