Exchange Rates: Definitions and the Real Exchange Rate

Abstract

This note defines exchange rates and explains changes in exchange rates (appreciations and depreciations). The note also introduces the concept of the real exchange rate as an inflation adjusted measure of the purchasing power of a country's currency and as a measure of the competitiveness of a country's products. The note discusses factors that influence the real exchange rate. The note contains assignment questions.

Excerpt

UVA-BP-0457

EXCHANGE RATES:

DEFINITIONS AND THE REAL EXCHANGE RATE

What is an Exchange Rate?

An exchange rate is the price of one currency measured in terms of another currency. It measures how much of one currency you can purchase with the other currency. The exchange rate is frequently expressed as the domestic currency price of foreign exchange (direct quotation). For example, in Table 1 the U.S. Dollar price of one Euro on November 6, 2001 was 0.897 $ /€ (i.e., it took approximately $ 0.897 to purchase one Euro (1€=$ 0.897)).

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Keywords: exchange rate risk, inflation, appreciation, depreciation