Question : What is the term used to describe the difference between the nominal exchange rate and the inflation rate between two countries?
Option 1: Real exchange rate
Option 2: Cross exchange rate
Option 3: Forward exchange rate
Option 4: Spot exchange rate
Correct Answer:
Real exchange rate
Solution : The correct answer is a) Real exchange rate
The term used to describe the difference between the nominal exchange rate and the inflation rate between two countries is the real exchange rate.
The nominal exchange rate represents the rate at which one currency can be exchanged for another currency. It is the value that is typically quoted in the foreign exchange market.
However, the nominal exchange rate does not account for differences in inflation rates between the two countries. The real exchange rate takes into consideration the relative purchasing power of the currencies by adjusting the nominal exchange rate for inflation differentials.
The formula for calculating the real exchange rate is:
Real Exchange Rate = Nominal Exchange Rate x (1 + Inflation of Home Country) / (1 + Inflation of Foreign Country)
The real exchange rate reflects the competitiveness of goods and services between two countries and plays a crucial role in international trade and investment decisions. It helps determine the relative prices of goods and can impact trade flows and economic competitiveness.
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