What is the difference between nominal and real exchange rate, and why is real exchange rate important for trade competitiveness?

• A. Nominal exchange rate is the price of one currency in terms of another
• B. Real exchange rate adjusts the nominal rate by relative price levels
• C. Real exchange rate is always higher than nominal
• D. Real exchange rate is irrelevant to trade

Answer: (B)

The main idea is that the nominal exchange rate is just the price of one currency in terms of another, while the real exchange rate adjusts that price by the relative price levels in the two countries. The real rate takes the nominal rate and multiplies it by the domestic price level divided by the foreign price level, so it shows how expensive domestic goods are relative to foreign goods after accounting for inflation. This matters for trade competitiveness because buyers compare prices across countries after considering how expensive goods really are, not just the currency price tag. If domestic inflation pushes the real exchange rate up (real appreciation) while the nominal rate stays the same, domestic goods become pricier abroad, reducing exports and making imports cheaper. If the real rate falls (real depreciation), domestic goods look cheaper abroad, boosting competitiveness. The real exchange rate captures those relative costs that drive trade flows, beyond what the nominal rate alone indicates. It’s not always higher than the nominal, and it is relevant to trade.