Real Exchange Rate

For every nominal exchange rate, there’s a real exchange rate.

The nominal exchange rate is how much of one currency you can get for another. For one U.S. dollar, you could get 65.10 Russian Rubles, 7.84 Hong Kong dollars, or 1.43 Australian dollars. This is what you want to know when you’re standing at a currency exchange counter, or you’re at an ATM in a foreign country. Fair enough.

The real exchange rate is how much goods and services in your country can be exchanged for goods and services in the foreign country. Yep, a bit more complicated.

[Real exchange rate] = [nominal exchange rate] x [domestic prices] / [foreign prices]

Let’s take the cost of a pineapple bun in Hong Kong. Say it’s $5 Hong Kong dollars. In the U.S., you can get a pineapple bun for $2 (if you can find it). If the exchange rate is 1:7.84, then here’s our real exchange rate:

$7.84 HKD x $2 USD / $5 = about 3.14 pineapple buns

That means you can get 3.14 pineapple buns in Hong Kong for every 1 pineapple bun in the U.S.

Rather than calculating the real exchange rate for every single good, economists are more likely to use price indexes, i.e. baskets of goods, to get a macroeconomic real exchange rate.