Changes in Real Exchange Rates

• Nominal Exchange Rates represent how many units of one currency can be exchanged for one unit of another currency.

• Nominal exchange rates are the rates quoted in the global markets for foreign currency exchange.

• Real Exchange Rates represent the amount of purchasing power in one currency can be exchanged for one unit of another currency.

• Example: 10 Euros buys one "global burger joint chain meal deal" in Paris; converting 10 Euros to US dollars and going into the same chain in downtown Cincinnati buys 1.5 of the same meal deals.

• Determining Change to Real Exchange Rate

• Real and Nominal Exchange Rates under PPP

SR X/Y = SN X/Y / (PX / PY)

• SR X/Y = Real X/Y exchange rate measuring purchasing power

• SN X/Y = The nominal X /Y exchange rate; i.e. the forex market quote

• PX = Price of a standard basked of goods in country X

• PY = Price of the same basket of goods in country Y

• Percent Change of the Nominal Exchange Rate under PPP

% SN PPP X/Y = ((1 + I X )/ (1 + I Y )) - 1

• I = Inflation rate over measurement period

• The amount of change in the real exchange rate between the currencies of two countries can be calculated by comparing an observed change in nominal exchange rates of the two currencies with the currency change predicted by Purchasing Power Parity.

% SR X/Y = ((1 + %ΔS N X/Y ) / (1 + % SN PPP X/Y )) - 1

• The real exchange rate between two currencies will change whenever the nominal exchange rate changes by an amount that is not explained by inflation.