Nominal vs. Real Exchange Rates

The nominal exchange rate is the 'as-is ratio right now' at which two currencies are exchanged in the market. When the news says 'the won/dollar rate is 1,300 won,' this is exactly the nominal exchange rate.

It moves in real time according to supply and demand in the foreign-exchange market, and it's also what we encounter when we exchange currency. It's very intuitive. It's the price tag itself: how many won you need to exchange for one dollar.

But there's a trap here. The nominal exchange rate says nothing about 'how different the two countries' price levels are.' Even if the exchange rate is unchanged, if Korean prices rise much faster than U.S. prices, the goods you can buy in Korea with the same dollar gradually shrink.

The real exchange rate is a value that reflects the two countries' price differences in the nominal exchange rate and adjusts it to a 'real purchasing power' basis. The basic formula used by the IMF and various economics textbooks is as follows.

Real exchange rate (RER) = nominal exchange rate (e) × foreign price level (P*) ÷ domestic price level (P)

In words, it expresses 'how many of our goods a foreign good can be exchanged for.' If the nominal exchange rate is simply the 'won-vs-dollar price tag,' then the real exchange rate is the 'real exchange ratio at which Korean goods and U.S. goods are swapped.'

So even if the nominal exchange rate is the same, if Korean prices rise more, the real exchange rate changes. Because prices are involved, the two indicators often move in different directions.

Korea doesn't trade only with the U.S. It deals with many countries — China, Japan, the EU, and more. That's where the 'effective exchange rate' comes in.

First, the nominal effective exchange rate (NEER) is the nominal exchange rate against major trading partners' currencies, weighted by trade share. And the real effective exchange rate (REER) reflects even the price differences on top of that.

REER is usually published as an index that sets a specific base point at 100. You interpret it like this.

① REER above 100 → the home currency is relatively overvalued compared with the base point ② REER below 100 → relatively undervalued

The reason the Bank of Korea and others watch REER is that it lets you comprehensively gauge how our exports' price competitiveness stands relative to trading partners. It's a picture you'd miss looking only at the nominal exchange rate.

If the real exchange rate feels hard, the 'Big Mac Index' created by the British magazine The Economist in 1986 is a good analogy.

It's an indicator that compares how much a single Big Mac costs in each country to show, in a fun way, whether a currency is overvalued or undervalued. This leans on the concept of purchasing power parity (PPP), that 'the same good should cost about the same anywhere.'

For example, if a Big Mac is $5.58 in the U.S. and £4.19 in the U.K., the Big Mac-based 'implied exchange rate' is about 0.75. If the actual market rate were 0.78, you'd interpret it as the pound being slightly (about 3% in this example) undervalued.

Of course, the Big Mac isn't a perfect indicator, since ingredients, labor, and taxes differ by country. But it conveys very intuitively the core of the real exchange rate: 'you can't know true value from the nominal exchange rate alone; you must view it together with prices.'

When you invest in overseas assets, the return is determined by 'the change in asset price × the change in the exchange rate.' Even if a U.S. stock rises, if the dollar weakens against the won in the meantime, the return converted to won can shrink. In the opposite case, an FX gain can be added.

On top of this, one more layer: the real exchange rate tells you about the variable of 'prices.' It means that even if the nominal return is positive, the real purchasing power adjusted for inflation can differ. So in long-term investing, you must view not only the nominal return but also the FX effect and prices (purchasing power) together.

This article is not at all about telling you to buy or sell a particular currency or asset. Its aim is to view the 'hidden variables' of exchange rates and prices together, without hiding them. On 'The Return of Almost Everything,' you can directly simulate how the exchange rate affected the actual performance of overseas assets when converted to won, and how the result changes when you reflect prices (inflation).