A nominal exchange rate move is simply the total observed movement in the exchange rate.It is not adjusted for inflation or for any other factor.A real exchange rate move is the nominal -rate movement adjusted for the differential in inflation.
For example , if British inflation has been 10 percent over the past year,while German inflation has been 0 percent,and the pound sterling devalues against the mark by 10 percent in the same time period,the nominal rate movement would be 10 percent,but the real adjustment is zero. We would say that nothing has happened.It takes 10 percent more pounds to buy a mark and therefore ,10 percent more pounds to buy a loaf of bread in Germany.However,it also takes 10 percent more pounds to buy a loaf of bread in England because of the 10 percent inflation there.In other words,German bread still costs the same as English bread,the basic exchange rate between English and German goods has not changed.There has been no change in the real exchange rate,for either goods or money.
An adjustment in the real currency exchange rate is , therefore, one that represents an adjustment in the exchange rate for real goods and services.If the rate of inflation is the same in each country and the exchange rate moves,a real rate move has occurred.If a bushel of British wheat costs 1 pound,and 1 pound buys 1 mark ,and 1 mark buys 1 pair of German shoes,then the bushel of wheat is worth a pair of shoes and can be exchanged for those shoes by selling the wheat for 1 pound,exchanging the pound for a mark ,and using the mark to buy the shoes.Now , if there is no inflation anywhere,there is no change in either the pound price of wheat or the mark price of shoes.However,over time,a currency rate move,to 2 marks per pound for example,will alter this relationship.The wheat can still be sold for a pound but the pound will now buy 2 marks,which will buy not one pair but 2 pairs of shoes.Because the exchange rate for real goods(wheat for shoes) has been altered,a real currency rate move has occurred.
As illustrated by the preceding example,the distinction between a real and a nominal currency rate is important .
Patrick Abboud
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