Nominal exchange rates indicate the value of one currency in terms of another, whereas real exchange rates adjust this value for inflation.

Nominal exchange rates are the rates at which one can exchange a currency for another. For instance, if the nominal exchange rate between the British pound ($\text{GBP}$) and the US dollar ($\text{USD}$) is $1.3$, it means that $1$ pound can be exchanged for $1.3$ dollars. These nominal exchange rates are commonly quoted in the foreign exchange market and are utilized in most international financial transactions.

In contrast, real exchange rates consider the relative purchasing power of the two currencies by accounting for differences in price levels or inflation rates between the countries involved. This adjustment is crucial because inflation can erode the value of money over time. If prices are increasing at a faster rate in one country compared to another, the real value of its currency will diminish, even if the nominal exchange rate remains constant.

For instance, if the nominal exchange rate between the pound and the dollar remains at $1.3$, but prices in the UK are rising more quickly than those in the US, this implies that a pound buys fewer goods and services in the UK than before, indicating a decline in its real value. Consequently, the real exchange rate would be lower than the nominal rate in this scenario.

Grasping the distinction between nominal and real exchange rates is essential for international trade and investment decisions. Nominal rates inform you about the exchange quantity between currencies, while real rates reveal the actual purchasing power of that currency in a foreign context. A high real exchange rate suggests that your currency has significant purchasing power abroad, making foreign goods and investments appear more affordable. Conversely, a low real exchange rate indicates that foreign goods and investments may seem expensive.

In summary, while nominal exchange rates are valuable for assessing the relative value of currencies, real exchange rates offer a more comprehensive understanding by incorporating the impact of inflation.