Currency is complicated and its value can be measured in several different ways. For example, a currency can be measured in terms of other currencies, or it can be measured in terms of the goods and services it can buy. An exchange rate between two currencies is defined as the rate at which one currency will be exchanged for another. However, that rate can be interpreted through different perspectives. Below are descriptions of the two most common means of describing exchange rates.
Nominal Exchange Rate
A nominal value is an economic value expressed in monetary terms (that is, in units of a currency). It is not influenced by the change of price or value of the goods and services that currencies can buy. Therefore, changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.
When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms. The nominal rate is set on the open market and is based on how much of one currency another currency can buy.
Real Exchange Rate
The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country's currency necessary to buy a market basket of goods in the other country, after acquiring the other country's currency in the foreign exchange market, to the number of units of the given country's currency that would be necessary to buy that market basket directly in the given country. The real exchange rate is the nominal rate adjusted for differences in price levels.
A measure of the differences in price levels is Purchasing Power Parity (PPP) . The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries' currencies. Using the PPP rate for hypothetical currency conversions, a given amount of one currency has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency.
Groceries
Purchasing Power Parity evaluates and compares the prices of goods in different countries, such as groceries. PPP is then used to help determine real exchange rates.
If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1. However, since these assumptions are almost never met in the real world, the real exchange rate will never equal 1.
Calculating Exchange Rates
Imagine there are two currencies, A and B. On the open market, 2 A's can buy one B. The nominal exchange rate would be A/B 2, which means that 2 As would buy a B. This exchange rate can also be expressed as B/A 0.5.
The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries. So, in this example, say it take 10 A's to buy a specific basket of goods and 15 Bs to buy that same basket. The real exchange rate would be the nominal rate of A/B (2) times the price of the basket of goods in B (15), and divide all that by the price of the basket of goods expressed in A (10). In this case, the real A/B exchange rate is 3.