Question

explain the difference between the real exchange rate and the purchasing power parity(PPP) exchange rate, and discuss a situation in which you would use each of these different exchange rates.

Answer 1

Nominal exchange rate is the units of one currency is exchange with one unit of other currency for an example

Nominal exchange rate of USD/INR =66 that means for 1 USD we can get 66 Indian Rupees.

Real exchange rate is inflation adjusted nominal exchange rates.

Real Exchange rate= Nominal Exchange Rate×(1+Inflation Rate)

Purchasing Power Parity (PPP) exchange rate is nothing but the cost of bundle comprising of same goods and services in two different countries.It actually counts for living standards in different countries.

In simple terms when to measure the living standards across the country for an instance Big Mac Index is actually use PPP with the help of Mac prices across the countries and then calculate the currency value in USD term for other Non US countries.

For Financial transactions real exchange rate is used more often