Nominal and Real Exchange Rates

The exchange rate is the number of units of one currency (called the price currency) that one unit of another currency (called the base currency) will buy.

Or, the cost of one unit of the base currency in terms of the price currency.

USD/EUR exchange rate of 1.2875

1 euro will buy 1.2875 US dollars (i.e., 1 euro costs 1.2875 US dollars).

A decline in this exchange rate indicates that the USD is appreciating against the EUR or, equivalently, the EUR is depreciating against the USD.

Real exchange rates: Adjust the nominal exchange rate by using the price levels in each country of the currency pair in order to compare the relative purchasing power between countries.

Purchasing power parity (PPP) asserts that nominal exchange rates adjust so that identical goods (or baskets of goods) will have the same price in different markets.

The purchasing power of different currencies is equalized for a standardized basket of goods.

Foreign price level in domestic currency = S_d/f × P_f

where

S_d/f is the spot exchange rate (quoted in terms of the number of units of domestic currency per one unit of foreign currency)

P_f is foreign price level quoted in terms of the foreign currency.

The ratio between the foreign and domestic price levels is:

Real exchange rate_(d/f) = (S_d/f × P_f)/P_d = S_d/f× (P_f/P_d)

where P_d is the domestic price level, in terms of the domestic currency.