Measuring exchange rates
Definition
Nominal exchange rate: the market price of one currency in terms of another, unadjusted for differences in price levels.
Real exchange rate: the nominal rate adjusted for relative price levels, showing the true competitiveness of a country's goods.
Trade-weighted (effective) exchange rate: an index of a currency's value against a basket of trading partners, weighted by each partner's share of trade.
- There is no single measure of a currency's value, because it can be measured in different ways.
- The three main measures are the bilateral nominal rate, the trade-weighted (effective) rate and the real exchange rate.
- Each gives a different view of a currency's value and competitiveness.
Key Idea
- A bilateral rate compares two currencies, while an effective rate compares one currency with many.
- A real rate adjusts for differences in prices between countries.
The three measures
- The bilateral nominal rate values one currency against a single other currency at current market prices, for example £1 = $1.25.
- The trade-weighted (effective) rate averages the currency against a basket of trading partners, weighted by their share of trade.
- The real exchange rate adjusts the nominal rate for relative price levels, so it shows true competitiveness.
Note
- A currency can rise against one partner while falling against others.
- The effective rate captures this by averaging across all major partners.
Why the real rate matters
- The nominal rate alone can mislead, because it ignores inflation differences between countries.
- If domestic prices rise faster than prices abroad, exports lose competitiveness even at a stable nominal rate.
- The real rate corrects for this by scaling the nominal rate by the ratio of domestic to foreign prices.
- So a rising real rate signals a loss of competitiveness, whatever the nominal rate does.
Real exchange rate = nominal exchange rate × (domestic price index ÷ foreign price index)
Example
- The nominal rate is unchanged. Domestic prices rise 10% while foreign prices are flat, so the price ratio rises from parity as shown.
- The real rate rises about 10%, so exports become less competitive even though the nominal rate has not moved.
Exam technique
- State which measure you are using, since each answers a different question.
- Use the effective rate to judge overall competitiveness, not a single bilateral rate.
- Use the real rate when inflation differences matter.
- Link the measure back to exports and imports.
Common Mistake
- Do not judge overall competitiveness from a single bilateral rate; a currency can move in opposite directions against different partners.
- Do not ignore inflation when discussing competitiveness; only the real exchange rate accounts for relative prices.
Self review
- Name the three ways of measuring an exchange rate.
- What is a trade-weighted (effective) exchange rate?
- How does the real exchange rate differ from the nominal rate?
- Why can a single bilateral rate be misleading?
- Which measure best reflects competitiveness, and why?
