What's the difference between the nominal exchange rate and the ...

[Alygatorr01285]

What's the difference between the nominal exchange rate and the real exchange rate?
 
  What will be an ideal response?

Question 2

Suppose the velocity of money is not fixed, but stable at about two percent growth per year.
 
  How could the quantity theory of money be modified to include a stable growth rate of the velocity of money? In this modified quantity theory of money with velocity growing at two percent per year, what would the growth rate of the other variables in the theory need to be to cause inflation?

[cpetit11]

Answer to Question 1

The nominal exchange rate measures the value of one country's currency in terms of another country's currency. The real exchange rate measures the price of domestic goods in terms of foreign goods. Mathematically, the real exchange rate is equal to the nominal exchange rate times the ratio of the domestic price level to the foreign price level.

Answer to Question 2

The quantity theory of money would have to include a growth rate for the velocity of money of about two percent, instead of zero percent. The inflation rate would then be determined by the following equation:
Inflation rate = Growth rate of the money supply + Growth rate of the velocity of money - Growth rate of real GDP.
Inflation would occur if the growth rate of the money supply plus the two percent growth rate of the velocity of money exceeds the growth rate of real GDP. In other words, the growth rate of the money supply must be two percent less than the growth rate of real GDP, or inflation will occur.