The exchange rate can be understood as the price of one currency in terms of another currency. It is the ratio between two currencies, the rate at which one can be exchanged for another. This ratio is very important since it is widely used when dealing with international payments or transfers, as well as when analysing open economies.
We have to distinguish between the base and the counter currency. In the adjacent example, currency A (CA) would be the counter currency while currency B (CB) would be the base currency.
Exchange rates are usually shown in terms of the base currency, being this a direct quotation if CA is the currency of our home country. This means, how many units of currency A I can get for one unit of currency B. The dollar is the most widely used currency as base currency, followed by the euro. Therefore, the exchange rate with another currency would be shown as follows:
Exchanges rates can also be expressed using indirect quotation, which might make more sense depending on each people’s needs:
Nominal vs. Real exchange rate:
We can make a distinction between nominal and realexchange rates.
The nominal exchange rate determines the price of the domestic currency in terms of the number of units of a foreign currency. In other words, the rate at which someone can trade the currency of their country for the currency of some other country. When we can buy an increasing number of units of foreign currency with the same amount of our domestic currency, our country’s currency is undergoing an appreciation. Conversely, when we can buy a decreasing number of units of foreign currency, our country’s currency is experiencing depreciation.
The difference between the nominal and the real exchange rate is that the real exchange rate takes into account the domestic and foreign prices, as summarized in the following formula:
This real exchange rate quantifies the price of a basket of goods and services available in one country relative to the same basket of goods and services available in the foreign country. An easy way to understand real exchange rates and purchasing-power parity is using the BigMac index, which expresses costs of living by comparing BigMac prices over the world.
Fixed vs. Flexible exchange rates:
Depending on whether or not the exchange rate is constant over time we are in a fixed or flexible exchange rate system.
In a fixed exchange rate system, the central bank sets, explicitly or implicitly, a particular exchange rate. To achieve this goal, monetary policy is used, increasing or decreasing the amount of money in the economy. A reduction in the exchange rate is called devaluation and an increase revaluation. Another option is fixing the currency of a particular country to a basket of currencies.
When the exchange rate system is flexible, the currency floats freely, so the international currency market sets its value. In this case we speak of depreciation when we have a reduction in the exchange rate and of appreciation when we have an increase. Fluctuations help moderate the effects of foreign economic cycles, automatically adjusting the balance of payments. Nowadays, most economies in the world have flexible exchange systems, or are really close to a floating system.