What is “Foreign Exchange”?

When we refer to foreign exchange, we are usually talking about the price at which one unit of a currency (for example a domestic currency, e.g. US dollar) trades or swaps for another (foreign currency, e.g. British pound) in the foreign exchange market.

Let’s look at an exchange rate in more detail with an example: if the current or prevailing exchange rate is US$10 for £1, then you have to give up US$10 to purchase £1. This is known as the nominal value (i.e. nominal exchange rate) of the (domestic) currency vis-à-vis the foreign currency. Similarly, the foreign exchange rates vis-a-vis other currencies such as the Euro, Yen, and Yuan among others is the price at which one unit of a currency (i.e. the domestic currency, for example, the US dollar) trades or swaps for these other currencies.

Key Learning Points

  • Foreign exchange is the process of switching a currency (usually domestic) into another currency (usually foreign) at an agreed exchange rate
  • The foreign exchange (forex) market is the largest investment market in the world operating 24 hours a day, 5 days a week
  • The real exchange rate is the nominal exchange rate adjusted for inflation
  • The Trade Weighted Exchange Rate is used to compare the nominal exchange rate of a country against those of its major trading partners
  • The Real Effective Interest Rates (REER) is the weighted average of the real exchange rates of a country with all its trading partners
  • In a flexible exchange rate system (i.e. floating exchange rate system), market forces of demand and supply largely determine the exchange rate between any two currencies
  • In a fixed exchange rate system, the government or the central bank of a country ties or pegs the country’s currency to either another country’s currency or to a basket of other currencies

Foreign Exchange – Important Terminologies

The Real Exchange Rate (RER) is the nominal exchange rate adjusted for inflation (calculated as the ratio of the domestic price level to the foreign price level or price level abroad multiplied by the nominal exchange rate). Essentially, the real exchange rate can be defined as the nominal exchange rate that takes the inflation differentials between countries into account.

The formula of Real Exchange Rate

Q = Pd x E
Pa

Where Q refers to the real exchange rate, E refers to the nominal exchange rate, Pd refers to the domestic price level and Pa refers to the foreign price level or price level abroad.

Trade Weighted Exchange Rate is calculated as a trade-weighted index (TWI), which is a measure of the nominal value of the domestic currency relative to the currencies of the domestic economy’s major trading partners. It is also known as the domestic currency’s effective exchange rate. It can be used to compare the nominal exchange rate of a country against those of its major trading partners.

Real Effective Interest Rates (REER) is the weighted average of the real exchange rates of a country with all its trading partners, with weights reflecting the importance of each trading partner (i.e. the importance of each trading partner’s currency in the domestic economy’s trade).

A higher (lower) REER indicates lower (higher) export competitiveness. Further, economists are mostly interested in the real effective exchange rate (REER).

In a flexible exchange rate system (i.e. floating exchange rate system), the market forces of demand and supply largely determine the exchange rate between any two currencies (for example, the value of the US dollar vis-à-vis the British pound), subjecting the same to considerable fluctuations (particularly in the short run) which often tends to be unpredictable or unexpected. The main currencies of the world (US dollar, British pound, Japanese yen, and Euro) today operate under the flexible exchange rate system and float independently against each other.

A fixed exchange rate system, also known as a ‘pegged’ exchange rate system, is one where the government or the central bank of a country ties or ‘pegs’ the country’s currency to either another country’s currency or to a basket of other currencies and agrees to maintain the value at that level. For example, Hong Kong pegs its currency to the US dollar. The key point to note is that the exchange rate under a fixed exchange rate system may be either higher or lower than the one determined by the market forces of demand and supply.

Real Exchange Rate – Relative Cost of Goods

The real exchange rate (RER) essentially informs us of what a specified amount of money (e.g. £100) can purchase in one country (in the UK), compared with what it can purchase in another country (e.g. in the US). It is basically the relative cost of goods in different economies – when expressed in a common currency. The real exchange rate measures the cost (i.e. price) of foreign goods relative to domestic goods and is, therefore, a measure of the competitiveness of a country’s exports relative to exports of its trading partners.

It must be clear from the formula of the real exchange rate that both price levels (domestic and foreign) and the nominal exchange rate can have an influence on its value. Further, the value of the real exchange rate varies directly with changes in the domestic price level and negatively or inversely with changes in the foreign price level. Moreover, the value of the real exchange rate also varies directly with changes in the nominal exchange rate.

In the workout below, we assume that the UK is the domestic economy and the US is the foreign economy. We assume that the nominal exchange rate is £1 = US$1and thus the cost of a typical basket of goods costs £100 in the UK and US$100 in the US. With this assumption, the RER is calculated. Thereafter, we assume that the cost of a typical basket of goods costs £130 in the UK, while the cost of the same remains US$100 in the US. Finally, the assumption is made that a typical basket of goods costs £80 in the UK, while the cost of the same remains US$100 in the US.

Exchange Rate Example

As the workout shows, When RER=1 the goods cost the same in the domestic economy as the foreign economy. When the RER rises >1 the goods are deemed more expensive in the domestic economy, and less expensive when the RER <1.