Question

The real exchange rate is the rate at which the currency of one country is traded for the currency of another country.

Short answer

Provide a brief explanation and an example. Answer: The real exchange rate is the rate at which goods and services from one country can be exchanged for goods and services from another country, considering the purchasing power of each currency. It differs from the nominal exchange rate, which only represents the rate at which one country's currency can be exchanged for another country's currency. The real exchange rate takes into account inflation in each country. For example, if the nominal exchange rate between Country A and Country B is 1 A currency = 2 B currency, and the price of a product in Country A is 5 A currency and the same product in Country B is 10 B currency, the real exchange rate would be: Real Exchange Rate = (Nominal Exchange Rate x Domestic Price) / Foreign Price Real Exchange Rate = (2 x 5) / 10 = 10 / 10 = 1 In this example, the real exchange rate of 1 indicates that the product costs the same in both countries when considering the nominal exchange rate and relative prices.

Step-by-step solution

Define the real exchange rate

The real exchange rate is the rate at which goods and services from one country can be exchanged for goods and services from another country. Essentially, it measures the relative price of goods between two countries and helps us understand which country's goods are more expensive in foreign markets.

Real vs. nominal exchange rate

The nominal exchange rate is the rate at which one country's currency can be exchanged for another country's currency. On the other hand, the real exchange rate considers the purchasing power of each currency, which is affected by inflation in each country.

How to calculate the real exchange rate

To calculate the real exchange rate, we can use the following formula: Real Exchange Rate = (Nominal Exchange Rate x Domestic Price) / Foreign Price Where Nominal Exchange Rate is the rate at which the currencies are exchanged, Domestic Price is the price of goods and services in the domestic country (in domestic currency), and Foreign Price is the price of goods and services in the foreign country (in foreign currency).

Example calculation

Let's take an example: Suppose the nominal exchange rate between Country A and Country B is: 1 A currency = 2 B currency And the price of a product in Country A is 5 A currency, and the price of the same product in Country B is 10 B currency. Using the real exchange rate formula: Real Exchange Rate = (Nominal Exchange Rate x Domestic Price) / Foreign Price Real Exchange Rate = (2 x 5) / 10 = 10 / 10 = 1 In this example, the real exchange rate is 1, which means that the product costs the same in both countries when we take into account the nominal exchange rate and the relative prices.