From Schweser: “Real exchange rate movements are changes in the exchange rate that are not fully explained by the inflation differential.” does that mean real does not include inflation? I’m confused Can someone please explain to me the differences between nominal and read? Thanks in advance.
A nominal change in currency rates can be explained through inflation(Purchaser Price Parity). If you adjust the currencies for PPP and they are not the same after a given time period then the currency relationship has experience a “real” movement. .i.e. look at the Greek debt crisis now. Why has the Euro depreciated -14.2% this year against the $US? Because real exchange rates have moved that cannot be explained though inflation. Real does not include inflation. “Real” is what you are left with once you factor inflation out of the equation. It’s a similar concept to real GDP vs. nominal GDP
thanks for the explanation
Yes, the change in real exchange rates is the change in nominal rates less the inflation differential. In other words, the real return it is the return you receive that does not come from differences in inflation between the two currencies. So for example, if you held a currency that had a nominal exchange rate moved from 1.00 to 1.04 but projected inflation in the domestic currency was 5% and projected inflation in the foreign currency was 1% the real movement of the exchange rate would be 0%. (1.04 - 1.00)/1.00 = 4% - (5% - 1%) = 0%. In other words, the movement of the exchange rate is fully explained by the inflation differential. If instead projected inflation of the domestic currency was 4% you would have a movement of the real exchange rate of 1%. (1.04 - 1.00)/1.00 = 4% - (4% - 1%) = 1% In other words, 1% of the exchange rate movement would not be explained by the inflation differential, thus real exchange rates would move by 1%. This would also mean that the purchasing power parity relationship would not hold.
awesome explanation