Summary
Exchange rates are measured in three main ways: nominal, real, and trade-weighted exchange rates. They can be determined under fixed and managed systems, and changes in exchange rates can have significant effects on the external economy.
- Nominal Exchange Rate — The price of one currency in terms of another currency. Example: 160 Pakistani rupees may buy one US dollar.
- Real Exchange Rate — Assesses changes in the competitiveness of a country's products in global markets. Example: A rise in the real exchange rate can lead to more imports and fewer exports.
- Trade-weighted Exchange Rate — A measure of a currency against a basket of currencies, weighted by trade importance. Example: If a country trades more with China than the US, the Chinese renminbi will have a higher weight.
- Fixed Exchange Rate — The government sets the currency value against another currency. Example: The UAE may fix its dirham at 1 dirham = US$0.25.
- Revaluation — Government raises the exchange rate to a new, higher fixed rate. Example: Central bank may buy currency to maintain the higher rate.
- Devaluation — Government reduces the price of the currency to a new, lower level. Example: Central bank may sell currency to maintain the lower rate.
Exam Tips
Key Definitions to Remember
- Nominal Exchange Rate
- Real Exchange Rate
- Trade-weighted Exchange Rate
- Fixed Exchange Rate
- Revaluation
- Devaluation
Common Confusions
- Confusing nominal and real exchange rates
- Misunderstanding the impact of inflation on exchange rates
Typical Exam Questions
- What is the impact of a devaluation on a country's exports? It makes exports cheaper and more competitive.
- How does a fixed exchange rate system work? The government sets and maintains the currency value against another currency.
- What factors influence the real exchange rate? Relative inflation rates and currency appreciation.
What Examiners Usually Test
- Understanding of different exchange rate systems
- Effects of exchange rate changes on trade balance
- Application of the Marshall–Lerner condition and J-curve analysis