NOMINAL OR REAL EXCHANGE RATES
• The rate at which an organization can trade the currency of one country for the currency of another is called a nominal exchange rate.
• The real exchange rate it is defined by the formula: RER = e(P/P*),
where
'e' is the number of foreign currency units per domestic currency unit,
P is the domestic currency price level,
P* is the foreign currency price level.
However, this formula is just a theoretical model and unfortunately, in practical usage, there are too many foreign currencies and price levels to consider. According to this, the calculations of the real exchange rate are much more complex. Moreover, the model is based on purchasing power parity, which involves a stable real exchange rate. The practical definition of a constant real exchange rate value could never be accomplished because of the limitations on data collection. The purchasing power parity would suggest that the real exchange rate is the rate at which an organization can trade goods and services of one economy for those of another one.
The actual rate of exchange can be influenced by the tariffs that government enacts in order to reduce price pressures. A big amount of macroeconomic variables such as relative productivity and the real interest rate differential are involved in modern ways to calculate the real exchange rate.
Fluctuations in exchange rates
A market based exchange rate will always fluctuate according to the alterations either of the two component currencies. When the demand for currency is bigger than its supply, the currency will appreciate. And on the contrary the currency will depreciate when the demand is less than supply (it doesn’t mean that people don’t want money, it just means that they would rather hold their capital in some other form, like another currency).
Increased transaction money demand or an increased speculative money demand usually cause the increased currency demand. Country's business activity level, level of gross domestic product and employment levels are interrelated to the transaction money demand. The amount of money the public as a whole spends on goods and services is inversely proportional to the number of unemployed people. Normally it’s easy for the central banks to adjust the available money supply to money demand changes because of business transactions.
It is much more difficult for a central bank to accommodate the speculative money demand and they do it by adjusting interest rates. Investors buy a currency if the interest rate is high enough. The amount of demand for a currency is proportional to the height of country's interest rates. Some say that currency speculation can decrease the country’s economic growth, for example, when large currency speculators create downward pressure on a currency and the central bank is forced to sell its currency to keep it stable (when it occurs, the speculators can redeem the currency from the bank at a lower price, close out their position, and gain a profit). When people decide in what form to hold their capital they acknowledge the importance of the assets to retain their value in some time and they will never be interested in the currency that is likely to devaluate.
If the country's inflation level is very high, if the level of output is decreasing, or if a country’s political situation is unstable, a currency will devalue to the currencies of other countries.
In the process of buying and selling currencies on the foreign exchange market just like at the stock exchange, money can be made or lost. Currency trading can be performed at spot and foreign exchange options markets. The spot market is referred to as current exchange rates, while options derive from exchange rates.
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