Exchange Rate Definitions:
- Nominal Exchange Rate: The nominal exchange rate is the relative value of one currency concerning another currency without adjusting for inflation. It reflects the exchange rate as stated in the foreign exchange market.
- Real Exchange Rate: The real exchange rate is the nominal exchange rate adjusted for inflation to provide a more accurate measure of purchasing power. It considers the relative price levels of two countries.
- Trade-Weighted Exchange Rate: The trade-weighted exchange rate is a weighted average of the exchange rate of a domestic currency concerning various foreign currencies. Each currency's weight is determined by its share in the country's total trade. This provides a more relevant measure for countries that engage in international trade, as it reflects their trading partners' currencies' importance.
Determination of Exchange Rates:
Floating Exchange Rate System:
In a floating exchange rate system, the value of a country's currency is determined by market forces of supply and demand. Governments and central banks do not actively intervene to fix the exchange rate. The exchange rate fluctuates in response to various factors, including interest rates, economic conditions, geopolitical events, and market sentiment. This system allows for flexible and real-time adjustments in exchange rates based on market conditions.
Fixed Exchange Rate:
In a fixed exchange rate system, the value of a country's currency is determined and maintained by the government or central bank in relation to other currencies. The government or central bank actively intervenes in the foreign exchange market to buy or sell its currency to keep its value fixed at a certain rate. This system aims to provide stability in exchange rates and can help facilitate international trade and investment by reducing uncertainty about currency values. However, maintaining a fixed exchange rate often requires significant reserves of foreign currency and may limit a country's ability to pursue independent monetary policies.
Different Measures of Exchange Rates:
- Bilateral Exchange Rate: The bilateral exchange rate is a direct comparison between two currencies, indicating the value of one currency relative to another. It doesn't account for living standards but is often used by travelers to understand the value of their currency in a foreign country.
- Effective Exchange Rate: The effective exchange rate provides a broader view by measuring the strength of one currency against a basket of other currencies, typically using an index. This index helps evaluate the overall performance of a currency in the foreign exchange market.
- Nominal Exchange Rate: Nominal exchange rates are not adjusted for inflation. They reflect the current price of one currency in terms of another currency. These rates can change as a result of various factors such as supply and demand in the foreign exchange market.
- Real Exchange Rate: The real exchange rate, in contrast, takes inflation into account. It adjusts the nominal exchange rate to reflect the difference in price levels between two countries. This adjustment helps assess the true purchasing power of a currency and its real value in international trade.
Depreciation and Appreciation:
- Depreciation: Occurs when the value of a currency falls relative to another currency. This typically happens in a floating exchange rate system where currency values are determined by market forces like supply and demand.
- Appreciation: Refers to an increase in the value of a currency. In this case, each unit of the domestic currency can buy more units of a foreign currency. For instance, if the pound appreciates, it will buy more dollars.
Devaluation and Revaluation:
- Devaluation: Occurs when a government officially lowers the value of its currency in a fixed exchange rate system. This adjustment is usually made to boost exports and correct trade imbalances.
- Revaluation: Is the opposite of devaluation and involves adjusting the currency's value upwards. It can be done concerning a baseline such as the price of gold, another currency, or wage rates. Revaluation often aims to stabilize the currency or address inflationary pressures.