exchange rate question

Question

Can someone help explain this? I dont understand the explanation, so any clarification would be appreciated. Further, how does an increase in real interest rate indicate the purchase power increase? From kaplan's book - I look at the equation on real exchange rate= nominal + base/price. One year ago, the nominal exchange rate for USD/EUR was 1.300. Since then, the real exchange rate has increased by 3%. This most likely implies that:A) the nominal exchange rate is less than USD/EUR 1.235.B)the purchasing power of the euro has increased approximately 3% in terms of U.S. goods.C)inflation in the euro zone was approximately 3% higher than inflation in the United States.ExplanationAn increase in the real exchange rate USD/EUR (the number of USD per one EUR) means a euro is worth more in purchasing power (real) terms in the United States. Changes in a real exchange rate depend on the change in the nominal exchange rate relative to the difference in inflation. By itself, a real exchange rate does not indicate the directions or degrees of change in either the nominal exchange rate or the inflation difference. (LOS 18.a)

cfachris · Answer

Real exchange rates take into account of effects of inflation, so it is a measure of what you can actually buy (i.e. purchasing power). So in this case, say 1 USD = 1 EUR at first, then if real exchange rates increase USD/EUR, it means 1 EUR can buy 3% more USD, i.e. purchasing power increases for EUR. So when looking at the equation:USDreal = USDnom / CPI-USD , where CPI represents consumer price index (a measure of inflation)andEURreal = EURnom / CPI-EURThus, the real exchange rate (USDreal / EURreal) relates to the nominal exchange rate (USDnom / EURnom) by:USDreal / EURreal = (USDnom / CPI-USD) / (EURnom / CPI-EUR) = (USDnom / CPI-USD) × (CPI-EUR / EURnom) = (USDnom / EURnom) × (CPI-EUR / CPI-USD) So when real exchange rates increases by 3% - and if that is the only information - we can't tell what direction and size of changes are happening with nominal exchange rates and ratio of inflation between those countries. That's what the last 2 sentences in the explanation meant. Does this help?