Question

1. Distinguish precisely between the real exchange rate and the nominal exchange rate.
                                                                                                                                       [8 marks]

Answer 1

Real Exchange rate illustrates the ratio of price in domestic market to foreign market which means it tells the number of units of goods purchased loaccly in exchange of imported good while Nominal Exchange rate illustrates the value of domestic currency in terms of foreign currency. Real Exchange Rate is calculated as: Nominal Exchange rate * (Domestic Price / Foreign Price). Financial institution generally represents nominal exchange rate. Fall in real exchange rate reduces the price of domestic goods in terms of imported goods which raised exports and reduces imports. On the other hand, fall in nominal exchange rate which is known as depreciation of domestic currency will result in more currency payable to buy the same unit of foreign currency.