Nominal, Real and Effective

Exchange Rate
By:- Chirag Patel
Nominal Exchange Rate
 In finance, the exchange rates is also known as the
foreign-exchange rate, forex rate or FX rate.
 Between two currencies it is specified by the exchange

rates that how much one currency is worth in terms of

the other.
 It is the value of a foreign nation’s currency in terms of

the home nation’s currency. ..

 For instance an exchange rate of 95 Japanese yen (JPY, ¥)

to the United States dollar (USD, $) means that the value

of JPY 95 is the same as USD 1.
Real Exchange Rate
 The level of the exchange rate taking account of inflation
differences.
 A way of measuring the price of foreign goods not just in
currency-adjusted terms but also in price-level adjusted
terms. ...

 The real exchange rate is normally termed the interbank

rate and is a number fixed at a certain time of day for banks
trading between themselves which is often used around
the world as the official rate.
Cont…
 For instance, the current "Real" rate between the US Dollar and
the Euro is:
1 USD = 0.767036 EUR and 1 EUR = 1.30372 USD.
 But when making exchanges of currency the bank normally

charges a fee for the transaction to pay for the processing and
as a hedge against a rate change occurring before they can
make a larger interbank exchange.
 Dollars for Euros you might get 0.72 Euros per Dollar rather

than the 0.767 Euro interbank (real) rate.

 On the flip side of that is changing your Euros for Dollars where

you might get 1.25 Dollars for each Euro exchanged instead of
the 1.30 interbank rate.
Cont..
 The RER is only a theoretical ideal.
 Many foreign currencies and price level values to take

into consideration.
 Furthermore, the model is based on purchasing power

parity (PPP), which implies a constant RER.

 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.
Effective Exchange Rate
 Effective exchange rate is weighted average of a basket of foreign
currencies.
 It can be viewed as an overall measure of the country's external

competitiveness.
 Nominal Effective Exchange Rate:-

a) A country's NEER is a weighted average of its currency exchange

rates with its major trading partners' currencies.
b) The weightings will be based on the level of trade with each
trading partner.
c) Thus a NEER gives a much better view of changes in a country's
terms of trade with the rest of the World than bilateral or SDR
rates.
Cont….
 Real Effective Exchange Rate:-
 An important refinement of the NEER is the Real Effective
Exchange Rate (REER).
 This is particularly useful in considering comparative changes
in a country's real economic circumstances.
 If the spot market rate for a country or its NEER shows a
downward trend this could be because other countries are
becoming relatively more productive. But it could arise from a
difference in inflation rates between that country and others
in the World.
 The REER is a NEER with price or labour cost inflation
removed.
Cont..
 The real exchange rate is defined as the nominal effective
exchange rate adjusted for movements in prices. It is
calculated as follows: