Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

10.5 THE REAL EXCHANGE RATE CONCEPT 
 
The real exchange rate is the relative price of two currencies 
after adjusting for change in domestic prices. Using purchasing 
power parity as benchmark, we can define another important 
exchange rate. This additional exchange rate is called the real 
exchange rate. The nominal price of a good is the price posted in 
the market place. Its real price is the nominal price adjusted for 
changes in the over all level of prices. For example: if the price of a 
burger increases from @ 2.00 to @ 2.20. In nominal terms, the 

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price of this good has risen by 10 percent. However, what has 
happened to the price of burger in relation to the prices of all other 
goods? To answer this question, we need information on the 
general level of prices within the nation.
Since the market reacts to the changes in real prices, it is 
important to know what is happening to the real price of a good or 
service
s. In similar vein, determining a country‘s real exchange rate 
is important as trade flows respond to changes in the real exchange 
rate just like the demand and supply of burger respond to the real 
prices of burger. The real exchange rate is important as trade 
inflows respond to changes in this exchange rate. there are three 
major factors that would cause the real exchange rate to change in 
the long run. These are: 
Changes in the foreign demand for domestically produced 
product 
C
hanges in nation‟s productivity
Changes in the real rate between nations (the real interest-
rate parity conditions) 
Check your progress: 
1) Define Real exchange rate.