Exchange Rates

The exchange rate (more accurately the nominal exchange rate) between two countries is the amount of the one country’s currency that can be bought with one unit of the other’s. For example, the UK-US exchange rate is often expressed as the number of UK£s that can be bought with one US$. It can also be expressed as the number of US$s equal to one UK£. Both ways are perfectly acceptable but, confusingly, there is no general agreement about which measure to use.

If the UK-US exchange rate is defined as the number of UK£s that can be bought with one US$ then a rise in the exchange rate means that the US dollar has appreciated in value – it will buy more UK£s – and the UK£ has depreciated in value. If the exchange rate is defined as the number of US$s that can be bought with one UK£ then a rise in the exchange rate means that the US$ has depreciated in value – it will buy fewer UK£s – and the UK£ has appreciated in value.

In the data provided here the nominal exchange rate is the amount of a country’s currency that can be bought with one US$. So a rise in its value implies a depreciation of the country’s currency against the US$. Other nominal exchange rates can be derived from these data. For example, if the UK-US exchange rate is 0.6 and the Euro-US exchange rate is 0.8 then the amount of UK£s that can be bought with one Euro is 0.6/0.8=0.75.

Until the early 1970s most countries operated within a fixed exchange rate system: the government decided a rate of exchange with the US$ and kept it there by buying their currency (using their foreign exchange reserves) or selling their currency (using their right to print it) on the foreign exchange market to remove any excess supply or demand on the foreign exchange markets at the desired exchange rate. Since the early 1970s governments have allow the exchange rate to be determined by the foreign exchange markets with little government intervention. In the case of Japan the period of floating exchange rates has led to a marked rise in the value of the Yen against the Dollar.

 

The real exchange rate is the number of baskets of goods and services typically produced in one country which can be acquired with one basket of goods and services typically produced in another. The UK-US real exchange rate will equal the price in US$s of a typical set of US goods and services multiplied by the nominal exchange rate (defined as the number of UK£s that can be bought with one US$) and then divided by the price in UK£s of a typical set of UK goods and services. Defined this way a rise in the real exchange rate implies that UK goods and services have become cheaper relative to those produced in the US – the UK has become more ‘competitive’.