Exchange rates are classified as real exchange rate, nominal exchange rate and effective exchange rates as explained below.
what is a Nominal Exchange rate?
Nominal exchange rates refer to the exchange rates that prevail in the market at a particular time. For example 1 USD = Rs. 63. Normally, the nominal rate is presented in an index form which gives an idea of the increase or the decrease in the price of one currency with the other.
What is a real exchange rate?
Real exchange rate is based on the purchasing power of currencies and it reflects the intrinsic value of one currency with the other. Suppose, in India the price of goods and services increase, which in USA, the price remains constant, then the real exchange rate of Indian rupee will go down in relation to that of American Dollar. This brings out the competitive exchange rate in favour of USA.
What is an Effective Exchange rate?
This is the exchange rate which is brought out by the impact of non tariff barriers which will make the import cheaper. In non tariff barriers, there may be a liberalized import policy by which more imports will be obtained and it may increase exports also. It depends on the current account balance of higher imports or higher exports.