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There are actually two types of exchange rates that we need to talk about.
- Nominal exchange rate – often denoted as (e)
- The cost of one currency in terms of another, or the rate needed to exchange the two currencies
For example go to http://www.xe.com/ucc/. We want to look at the exchange rate from the perspective of a citizen of the United States, so select “United States Dollars – USD” in the “From this currency” box. Let’s say we are interested in changing our dollars into euros – select “Euro – EUR” from the “To this currency” box.
As of June 12, 2008, 1 USD = 0.648 EUR. What this tells me is that if I were to take one of my dollars to a currency exchanger, I would get 0.648 euros in return. Note: Your result will be different, as the currency could have appreciated or depreciated.
This is written as e = 0.645 €/$ - you will get 0.645 Euros for every dollar!
If I were to take $100 to the exchanger, I would get 64.5 €.
Now that sounds like a pretty bad trade, but it might not be.
Look at the exchange rate between the dollar and the Hungarian Forint. On June 12th, 2008, $1 will buy 159.6 forint! With my $100 I could get 15,960 forint! You could be a millionaire with less than $10,000.
Should we take our dollars over to Hungary right now and live like a king? Maybe not; we need to know how much things cost in Hungary first, and that is why we need another definition
- Real Exchange Rate – often denoted as (ε)
- The nominal exchange rate adjusted for price differences in the two countries.
Let’s say there is only one thing in the world that you would ever need to buy – let’s call that thing a widget. You can eat it, wear it, or use it to build a house – if you need it the widget can do it.
So if a widget in the US costs $100 and a widget in Hungary costs 100 forint, then instead of taking my $100 and buying one widget in the US, I’ll take my $100 and exchange them for forint – getting 15,960 forint. I then use that to by 159 widgets – yes life is better.
However, this will most likely not be the case. If I were to go over to Hungary I would probably find that the cost of a widget was 16,000 Ft. If I took my $100 and exchanged them for forint (getting 15,960 Ft.), I would not even be able to buy one widget – I’m not that rich after all!
Illustrated below is the nominal exchange rate for the dollar versus the euro and British pound. A fall in the exchange rate represents a depreciation of the dollar.