Importance of the Real Exchange Rate
The distinction between the nominal exchange rate and the real exchange rate is important because of their vastly different implications for exchange risk. A dramatic change in the nominal exchange rate accompanied by an equal change in the price level should have no effects on the relative competitive positions of domestic firms and their foreign competitors and, therefore, will not alter real cash flows. Alternatively, if the real exchange rate changes, it will cause relative price changes—changes in the ratio of domestic goods’ prices to prices of foreign goods. In terms of currency changes affecting relative competitiveness, therefore, the focus must be not on nominal exchange rate changes, but instead on changes in the purchasing power of one currency relative to another. Put another way, it is impossible to assess the effects of an exchange rate change without simultaneously considering the impact on cash flows of the underlying relative rates of inflation associated with each currency.