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  Nominal Vs Real Exchange Rates and measuring the Macroeconomy

Nominal Vs Real Exchange Rates:

The nominal exchange rate is relative price of two different kinds of money, as placed in the foreign exchange market. Domestic exporters make foreign currency when they export i.e. sell goods to public abroad. Foreign manufacturers earn domestic currency when they sell us imports, sell their supplies to people here. Both then have problem. Domestic exporters cannot pay domestic workers with foreign currency. Foreign manufacturers cannot pay foreign workers with domestic currency. Foreign producers are required to trade the dollars they have earned for money which is useful to them. Domestic manufacturers are required to trade the foreign currency which they have earned for dollars they can use.

How do foreign manufacturers and native exporters solve this problem? They go around the foreign exchange marketplace, where those who have foreign currency but wish for dollars exchange it for dollars, and the persons who have dollars but wish for foreign currency exchange dollars for other currencies.

If the nominal exchange rate amid the dollar (the currency of U.S.) and the euro (the currency of Europe Union) is $1.20 = ¤1.00, i.e. a single euro is equal to $1.20 in U.S. currency. It takes less than one euro (to be exact 0.83 Euros) and change to buy a single dollar.

Economists, though, are more interested in the ‘real exchange rate’ which is nominal rate adjusted for changes in the value of currency.

Presume that a burst of inflation were to twice over the price level in the U.S, so that everything which formerly cost $1 in the U.S. now costs $2, everything that used to charge $2, now costs $4, and so on. Now Assume that nominal exchange rate were to change from $1.20 = ¤1.00 to $2.40 = ¤1.00. Before the burst of inflation you might sell goods in Europe for ¤0.83 (and change), turn the Euros in $1.00, and buy American goods. After the burst of inflation you could sell goods in Europe for ¤0.83 (and change), change the Euros in $2.00, and buy the exact equal American goods as before. The change in the nominal exchange rate has offset change in the United Nations price level. In that case real exchange rate which is the rate at which goods trade for goods has not changed. The terms at which the merchandises of one nation are traded for the goods of another are the same.

Now assume that burst of inflation were to twice over the price level in the U.S., but that $1.20 still exchanges for ¤1.00 on foreign exchange marketplace. Has the exchange rate changed?  Nominal exchange rate hasn’t changed: 0.83 (plus change) Euros will still get you a dollar; $1.20 will still get you a paper euro. but, that paper dollar would buy only as many supplies in the U.S. as fifty cents would have bought before. The doubling-up of the U.S. price level, coupled with the unchanged nominal exchange rate, means that similar quantity of U.S. made goods would buy twice as many European made goods. So the real exchange rate has halved.

To compute the real exchange rate you need to know 3 pieces of information. First, you need to know the price level in the domestic nation call it P, for price. Second, you need to know the price level abroad call it by P*. (It is conventional in macroeconomics to let *s stand for values overseas in foreign nations.) Third, you need to know nominal exchange rate call it e, for exchange. You can then computer the value of the real exchange rate by multiplying the nominal exchange rate by ratio of the domestic price level to the overseas price level:

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