Working with Exchange Rates: Common Definitions and Predictions
Part of the International Finance For Dummies Cheat Sheet
There are some basic definitions in international finance which you should remember. Additionally, knowing the long-run relationships between macroeconomic fundamentals and exchange rates help you predict the direction of the change in exchange rates. Check out these tips to step up your exchange rate know-how:
Exchange rate as a relative price. The dollar-euro exchange rate indicates the amount of dollars necessary to purchase one euro. If the exchange rate is $1.31, it means that you need $1.31 per euro.
Real vs. nominal exchange rates. Nominal exchange rates imply the relative price of two currencies. As in the case of $1.31 per euro, the only information you get out of nominal exchange rates is how many of one currency you need to buy one unit of the other currency. Real exchange rates compare the price of a consumption basket in one country to that of another country in the same currency.
Terminology for the changes in exchange rates. If both currencies in an exchange rate are freely traded in foreign exchange markets, you refer to changes in this exchange rate as depreciation or appreciation. If $1.31 changes to $1.35 per euro, this indicates depreciation of the dollar (appreciation of the euro). If the Chinese Yuan (CNY)-dollar exchange rate changes from CNY6.21 to CNY6.15, this shows revaluation of the Chinese Yuan, because the value of the yuan with respect to other currencies is determined by the Chinese government.
Nominal macroeconomic variables and exchange rates. When it comes to the long-run effects of nominal macroeconomic variables on exchange rates, remember this: Higher money supply growth rates, inflation rates, and nominal interest rates depreciate a currency. While, lower money supply growth rates, inflation rates, and nominal interest rates appreciate a currency.
Real macroeconomic variables and exchange rates. In terms of the long-run effects of real macroeconomic variables on exchange rates, remember the following: Lower real interest rates and growth rates depreciate a currency and higher real interest rates and growth rates appreciate a currency.