UVA-BP-0457

EXCHANGE RATES:
DEFINITIONS AND THE REAL EXCHANGE RATE

What is an Exchange Rate?

An exchange rate is the price of one currency measured in terms of another currency. It
measures how much of one currency you can purchase with the other currency. The exchange
rate is frequently expressed as the domestic currency price of foreign exchange (direct
quotation). For example, in Table 1 the U.S. Dollar price of one Euro on November 6, 2001 was
0.897 $/€ (i.e., it took approximately $0.897 to purchase one Euro (1€=$0.897)).

An alternative way to express an exchange rate is to state how many units of domestic
currency (e.g., U.S. Dollars) you can buy with one unit of foreign currency (indirect quotation).
For example, Table 1 indicates that you could purchase approximately € 1.11 with one U.S.
Dollar ($1=€1.11).

It is important to pay attention to the way that an exchange rate is quoted when
interpreting exchanges rates and movements in exchange rates.

Direct Quotation*:

Domestic Currency Price of Foreign Exchange =

Amount of $ needed to buy one € = $/€

Indirect Quotation:

Foreign Currency Price of Domestic Exchange =

Amount of € that can be bought with one $ = €/$

* The $ is the domestic currency throughout this note, and the Euro is
the foreign currency

This note was prepared by Petra Christmann, Assistant Professor of Business Administration. Copyright  2002 by
the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies,
send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval
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Currency Appreciation and Depreciation

Currencies often fluctuate in value. In a system where the value of the currency is
determined by market forces (flexible or floating exchange rates), these fluctuations are referred
to as appreciation and depreciation. In a system in which the value of the currency is fixed by
the government (fixed exchange rates), the value of the currency only varies if the government
decides to change the value of the currency. In this system the fluctuations are referred to as
revaluation and devaluation.

An appreciation (revaluation) of one currency versus another currency means that the
currency increases in value relative to the other currency. For example, the U.S. Dollar might
appreciate against the Euro. This means that it will take fewer U.S. Dollars to purchase one
Euro, or alternatively that it will take more Euros to buy one U.S. Dollar. The exchange rate
quoted as US$/€ (direct quotation) will decrease, as fewer U.S. Dollar are required to buy one
Euro (i.e., the U.S. Dollar price of Euros declines). Alternatively, the exchange rate quoted as
€/$ (indirect quotation) will increase, as more Euros are required to buy one U.S. Dollar (i.e., the
Euro price of Dollars increases).

A depreciation of the currency has the opposite effects. If the U.S. Dollar depreciates
against the Euro the Dollar price of one Euro will increase—the exchange rate quoted as $/€ will
increase--while it takes fewer Euros to purchase one Dollar—the exchange rate quoted as €/$
will decrease.

For example, Table 1 shows that the Dollar/Euro exchange rate increased from 0.897 $/€
on November 6, 2001 to 0.899$/€ on November 7, 2001. This means that the Dollar has
depreciated between November 6 and November 7, while the Euro has appreciated. It now takes
more Dollars to buy one Euro. By the same token, one Dollar buys only 1.111 Euros on
November 7 compared to 1.114 Euros on the previous day.

Increase in Value of Dollar Decrease in Value of Dollar

Flexible Exchange Rates Appreciation Depreciation
Fixed Exchange Rates Revaluation Devaluation
What happens to exchange
rate?
Direct Quotation Exchange rate decreases Exchange rate increases,
e.g., $/€↓ e.g., €/$↑
Indirect Quotation Exchange rate increases, Exchange rate decreases,
e.g., €/$↑ e.g., €/$↓
 -3- UVA-BP-0457

Nominal and Real Exchange Rates

So far, we have looked at nominal exchange rates, the actual stated rates at which
currencies are exchanged for one another. The real exchange rate (RER) is an important concept
that provides an inflation-adjusted measure of the purchasing power of a country’s currency and
indicates changes in the international competitiveness of domestic versus foreign goods.

Why adjust for inflation? The price of a domestic good in a domestic currency—the
price of a U.S.-made car in Dollars—can change in two ways relative to the price of a foreign
good in the domestic currency—the Dollar price of a European-made car. First, changes in the
exchange rate will induce changes in the Dollar price of a European-made car. Second,
differences in the inflation rates between the United States and Europe can affect relative prices
of the two cars.

A nominal appreciation of the U.S. Dollar versus the Euro will reduce the Dollar price of
the European made car. Assume the price of the car is €20,000 and the exchange rate is
0.897$/€. This means that the car costs $ 17,940 (=€20,000*0.897 $/€). Now assume that the
U.S. Dollar appreciates so that it now only takes $0.75 to buy one Euro (i.e., the exchange rate
decreased to 0.75$/€). Now it costs approximately $15,000 to buy the same car. The Dollar
price of a car manufactured in the United States would not have been affected by these changes.
This means that the appreciation of the U.S. Dollar has increased the international
competitiveness of European products relative to U.S. products by making them relatively less
expensive in Dollars. By the same token, the international competitiveness of U.S.-made
products has decreased relative to European-made products.

If the inflation rate in the United States is greater than the inflation rate in Europe, there
will be strong forces causing the price of U.S.-made goods to increase relative to the price of
European-made goods. The international competitiveness of U.S.-made goods will likely
decline. Assume the inflation rate is 8 percent in the United States and only 3 percent in Europe.
In a year the price of the U.S.-made car will have increased by 5 percent more than the price of
the European-made car.

Nominal
appreciation
of U.S. Dollar
U.S goods become more
expensive in foreign currency Decline in international
competitiveness of U.S. made
Foreign goods become less goods relative to foreign goods
expensive in U.S. Dollars
U.S. inflation
higher than
foreign inflation
 -4- UVA-BP-0457

Combining these two factors—nominal exchange rates and international inflation rates—
yields the real exchange rate (RER), which is defined as:

RER= E * (PF/PD),

where E is the nominal exchange rate (direct quotation), PF is the foreign price level (e.g., a
foreign price index), and PD is the domestic price level (e.g., a domestic price index). Please
note that the RER is defined here using the direct quotation.

Changes in the RER over time provide information about the changes in international
competitiveness of a country’s goods resulting from nominal exchange rate changes and
international inflation rate differentials. An appreciation (decrease) in the RER indicates a loss
of international competitiveness of the domestic economy.

Appreciations in the RER can be caused by two factors: first, an appreciation (decrease)
of the nominal exchange rate, and second, a domestic inflation rate that is higher than the foreign
inflation rate (PF < PD
(PF/PD) < 1). Thus, in order to interpret the RER it is necessary to look
at changes over time. The value of the RER at any point in time does not provide any
information, as it is dependent on the base year used for the calculation of the price index used.

In the car example above, the RER before the changes in the exchange rate and the
effects of the inflation rate differentials was RER0=0.897$/€*(1/1)=0.897$/€. After the changes
the RER decreased to RER1 = 0.75$/€*(1.03/1.08)=0.715$/€. This means that the RER has
appreciated by 20.26 percent (0.897-0.715)/0.897)). This implies that, in real terms, the price of
a European-made car in Dollars has decreased by 20.26 percent. By the same token, the price of
U.S.-made cars in Europe has increased (see assignment question 3b below). This makes it more
difficult for U.S. firms to compete with European firms for sales in international markets. Thus,
the development of the RER over time provides valuable information about changes in the
international competitiveness of domestic firms relative to foreign firms.

Nominal
appreciation
of U.S. Dollar
Real Exchange Rate Decline in international
appreciation of the U.S Dollar competitiveness of U.S. made
goods relative to foreign goods

U.S. inflation
higher than
foreign inflation

In the example above, both the nominal appreciation of the Dollar versus the Euro and
the higher inflation rate in the United States versus Europe contribute to the appreciation of the
real exchange rate. It is also possible that the two effects work in opposite directions. For
 -5- UVA-BP-0457

example, the negative effect of high domestic inflation on competitiveness can be offset by a
nominal depreciation or a devaluation of the domestic currency. Or the negative effect of a
nominal appreciation of the domestic currency on competitiveness can be offset by lower
inflation rates than foreign competitors. It is important to look at relative changes in the price
levels and changes in the nominal exchange rate simultaneously to evaluate the effects of
changes in these variables on international competitiveness. The RER is a useful concept that
combines these two aspects.

Assignment Questions

1. Exchange rate definitions:

a. How many Dollars were needed to buy one British Pound on November 6, 2001?
How many British Pounds were needed to buy one Dollar?
b. What is the Euro/Pound exchange rate?
2. Exchange rate changes:
a. Has the U.S. Dollar appreciated or depreciated versus the British Pound between
November 6 and November 7, 2001?
b. Has the Euro appreciated or depreciated versus the British Pound between November
6 and November 7, 2001?
3. Real Exchange Rates:
a. Evaluate the effect of a change in the exchange rate between the U.S. Dollar and the
Euro from 0.897$/€ to 0.75$/€ on the Euro price of a U.S.-made car. Assume the car
initially cost $20,000. How is the change likely to affect the U.S. Exports and
imports?
b. Evaluate the combined effects of the exchange rate change considered in Question 3a
above and inflation rates of 8 percent on the United States and 3 percent in Europe on
the Euro price of the U.S.-made car. How is the change likely to affect U.S. exports
and imports?
 -6- UVA-BP-0457

Tuesday, November 06, 2001 Wednesday, November 07, 2001

1 USD in USD 1 USD in USD
Argentine Peso 0.9995 1.0005 0.9995 1.0005
Australian Dollar 1.94894 0.513099 1.94099 0.515201
Austrian Schilling 15.3319 0.0652236 15.2909 0.0653986
Bahraini Dinar 0.376 2.65957 0.376 2.65957
Belgian Franc 44.9471 0.0222484 44.8269 0.022308
Botswana Pula 6.19963 0.1613 6.22278 0.1607
Brazilian Real 2.594 0.385505 2.6 0.384615
British Pound 0.685354 1.4591 0.682594 1.465
Canadian Dollar 1.5938 0.627431 1.5935 0.627549
Chilean Peso 541.15 0.00184792 540.76 0.00184925
Chinese Yuan 8.2767 0.120821 8.2766 0.120823
Colombian Peso 2309.42 0.00043301 2309.22 0.000433047
Czech Koruna 37.243 0.0268507 37.012 0.0270183
Danish Krone 8.3 0.120482 8.28 0.120773
Dutch Guilder 2.4554 0.407266 2.44883 0.408358
Euro 1.11421 0.897497 1.11123 0.899904
Finnish Markka 6.62479 0.150948 6.60707 0.151353
French Franc 7.30874 0.136823 7.28919 0.137189
German Mark 2.17921 0.458883 2.17338 0.460113
Greek Drachma 379.667 0.00263389 378.652 0.00264095
Hong Kong Dollar 7.8001 0.128203 7.8 0.128205
Hungarian Forint 280.97 0.0035591 278.15 0.00359518
Iceland Krona 106.11 0.00942418 105.23 0.00950299
Indian Rupee 48.04 0.020816 48.04 0.020816
Iraqui Dinar 0.310857 3.21691 0.310857 3.21691
Irish Punt 0.877512 1.13959 0.875165 1.14264
Israeli New Shekel 4.261 0.234687 4.265 0.234467
Italian Lira 2157.41 0.00046352 2151.64 0.000464761
Japanese Yen 121.15 0.00825423 121.05 0.00826105
Luxembourg Franc 44.9471 0.0222484 44.8269 0.022308
Malaysian Ringgit 3.8 0.263158 3.8 0.263158
Mexican Peso 9.2146 0.108523 9.211 0.108566
Nepalese Rupee 76.475 0.0130762 76.475 0.0130762
New Zealand Dollar 2.38039 0.420099 2.38095 0.42
Norwegian Kroner 8.856 0.112918 8.8315 0.113231
Omani Rial 0.3845 2.60078 0.3845 2.60078
Pakistan Rupee 61.5029 0.0162594 61.5029 0.0162594
Polish Zloty 4.095 0.2442 4.0662 0.24593
Portuguese Escudo 223.379 0.0044767 222.782 0.0044887
Qatari Rial 3.64 0.274725 3.64 0.274725
Saudi Riyal 3.75 0.266667 3.75 0.266667
Singapore Dollar 1.8181 0.550025 1.814 0.551268
Slovenian Tolar 245.443 0.00407427 244.021 0.00409801
South African Rand 9.458 0.105731 9.5425 0.104794
South Korean Won 1295 0.0007722 1292 0.000773994
Spanish Peseta 185.389 0.00539406 184.893 0.00540853
Sri Lanka Rupee 92.3 0.0108342 92.35 0.0108284
Swedish Krona 10.558 0.0947149 10.4685 0.0955247
Swiss Franc 1.64 0.609756 1.6328 0.612445
Taiwan Dollar 34.55 0.0289436 34.55 0.0289436
Thai Baht 44.67 0.0223864 44.65 0.0223964
Utd. Arab Emir. Dirham 3.6725 0.272294 3.6725 0.272294
Venezuelan Bolivar 744 0.00134409 744 0.00134409