Question

explain the difference between the real exchange rate and the purchasing power parity(PPP) exchange rate, and discuss a situation in which you would use each of these different exchange rates.

Answer 1

Real Exchange Rate-It is the ratio that denotes relationship between foreign currency and domestic currency. The prices of commodities of foreign country are converted in term of domestic currency to see the real value of currency.

Purchasing power parity- This is also an economic theory through which prices of basket of goods are analyzed in both the currencies, i.e Foreign as well as domestic. According to this theory, two country's currencies are at equilibrium when the price of basket of goods is same in both the currencies.

Difference between Real Exchange Rate & Purchasing power parity- Real exchange rate tells how many times, goods and services can be bought in foreign currency as compare to domestic currency. Purchasing power parity theory tells the ratio between two currencies of different countries based on their purchasing power.

Discuss a situation in which you would use each of these different exchange rates- These rates are used in international trade and Foreign direct investment and investment into public sector.