Let us take up a single transaction. Let us assume that an Indian resident wants to visit London on a vacation (an import of tourist services). She will have to pay in pounds for her stay there. She will need to know where to obtain the pounds and at what price. Her demand for pounds would constitute a demand for foreign exchange which would be supplied in the foreign exchange market – the market in which national currencies are traded for one another.
The major participants in this market are commercial banks, foreign exchange brokers and other authorised dealers and the monetary authorities. There is close and continuous contact between the trading centres and the participants deal in more than one market.
Note : Although the participants themselves may have their own trading centres, the market itself is world-wide.
The price of one currency in terms of the other is known as the exchange rate. Since there is a symmetry between the two currencies, the exchange rate may be defined in one of the two ways –
- First, as the amount of domestic currency required to buy one unit of foreign currency, i.e. a rupee-dollar exchange rate of ₹ 50 means that it costs ₹ 50 to buy one dollar, and
- Second, as the cost in foreign currency of purchasing one unit of domestic currency. In the above case, we would say that it costs 2 cents to buy a rupee.
The practice in economic literature, however, is to use the former definition – as the price of foreign currency in terms of domestic currency. This is the bilateral nominal exchange rate – bilateral in the sense that they are exchange rates for one currency against another and they are nominal because they quote the exchange rate in money terms, i.e. so many rupees per dollar or per pound.
However, returning to our example, if one wants to plan a trip to London, she needs to know how expensive British goods are relative to goods at home. The measure that captures this is the real exchange rate – the ratio of foreign to domestic prices, measured in the same currency. It is defined as –
Real Exchange Rate = ePf / P
- P and Pf are the price levels here and abroad, respectively;
- e is the rupee price of foreign exchange (the nominal exchange rate);
- The numerator expresses prices abroad measured in rupees;
- The denominator gives the domestic price level measured in rupees;
So, the real exchange rate measures prices abroad relative to those at home.
- If the real exchange rate is equal to one, currencies are at purchasing power parity. This means that goods cost the same in two countries when measured in the same currency.
- For instance, if a pen costs $4 in the US and the nominal exchange rate is ₹ 50 per US dollar, then with a real exchange rate of 1, it should cost ₹ 200 (ePf = 50 × 4) in India.
- If the real exchange rises above one, this means that goods abroad have become more expensive than goods at home. The real exchange rate is often taken as a measure of a country’s international competitiveness.
Since a country interacts with many countries, we may want to see the movement of the domestic currency relative to all other currencies in a single number rather than by looking at bilateral rates. That is, we would want an index for the exchange rate against other currencies, just as we use a price index to show how the prices of goods in general have changed.
- This is calculated as the Nominal Effective Exchange Rate (NEER) which is a multilateral rate representing the price of a representative basket of foreign currencies, each weighted by its importance to the domestic country in international trade (the average of export and import shares is taken as an indicator of this).
- The Real Effective Exchange Rate (REER) is calculated as the weighted average of the real exchange rates of all its trade partners, the weights being the shares of the respective countries in its foreign trade. It is interpreted as the quantity of domestic goods required to purchase one unit of a given basket of foreign goods.
Bibliography : NCERT – Introductory Macroeconomics