Nominal exchange rates

What Are Nominal Exchange Rates?

Nominal exchange rates represent the price of one currency in terms of another. Within the broader field of international finance, a nominal exchange rate is the rate at which one currency can be exchanged for another without regard to their respective purchasing powers. For instance, if the nominal exchange rate between the U.S. dollar and the Euro is 1.10, it means that 1 U.S. dollar can buy 1.10 Euros, or conversely, 1 Euro costs approximately 0.91 U.S. dollars. This rate is what you typically see quoted in financial news and is the basis for transactions in the foreign exchange market.

History and Origin

The concept of exchange rates is as old as international trade itself, evolving from barter to systems involving precious metals like gold. For much of the 20th century, particularly after World War II, a significant international monetary system that dictated how nominal exchange rates were managed was the Bretton Woods system. Established in July 1944 at a conference in Bretton Woods, New Hampshire, by delegates from 44 Allied nations, this system aimed to prevent the competitive devaluations that had destabilized international trade during the Great Depression. It created a system of fixed exchange rate arrangements where most member countries pegged their currencies to the U.S. dollar, and the U.S. dollar was, in turn, convertible to gold at a fixed price of $35 per ounce. This system became fully operational in 1958.⁷,⁶ The International Monetary Fund (IMF) was also created under this agreement to oversee exchange rates and provide financial assistance to countries facing balance of payments difficulties. However, persistent U.S. balance-of-payments deficits led to the system's collapse in 1971 when President Richard Nixon suspended the dollar's convertibility into gold, paving the way for the widespread adoption of floating exchange rate regimes seen today.⁵,⁴

Key Takeaways

• Nominal exchange rates state the price of one currency in terms of another.
• They are the most commonly quoted exchange rate and are used for immediate currency conversions.
• Changes in nominal exchange rates can lead to currency appreciation or devaluation, impacting trade and capital flows.
• Central banks and governments may intervene in the foreign exchange market to influence nominal exchange rates.
• Unlike real exchange rates, nominal exchange rates do not account for differences in price levels or inflation between countries.

Formula and Calculation

The nominal exchange rate is a direct ratio of two currencies. There isn't a complex formula in the same way as, say, a bond yield calculation. It is simply expressed as:

Or, conversely:

Where:

• (E_{nominal}) represents the nominal exchange rate.
• "Units of Foreign Currency" refers to the quantity of the foreign currency.
• "1 Unit of Domestic Currency" refers to a single unit of the home currency.

For example, if the nominal exchange rate between the Japanese Yen (JPY) and the U.S. dollar (USD) is 150 JPY/USD, it means that 1 U.S. dollar can be exchanged for 150 Japanese Yen. This quotation directly impacts the relative cost of goods and services when converted from one currency to another.

Interpreting the Nominal Exchange Rate

Interpreting the nominal exchange rate involves understanding what a change in this rate signifies for the relative value of two currencies. When the nominal exchange rate of a domestic currency against a foreign currency increases (e.g., from $1.00 = €0.90 to $1.00 = €0.95), it means the domestic currency has appreciated relative to the foreign currency. The domestic currency can now buy more units of the foreign currency. Conversely, a decrease in the nominal exchange rate (e.g., from $1.00 = €0.90 to $1.00 = €0.85) indicates that the domestic currency has depreciated.

These movements have direct implications for international trade and investment. A stronger domestic currency makes imports cheaper and exports more expensive for foreign buyers, potentially affecting a country's balance of payments. A weaker domestic currency has the opposite effect. Market participants, including individuals, businesses, and investors, constantly monitor these rates for various purposes, from planning foreign trips to conducting international transactions or assessing investment opportunities abroad.

Hypothetical Example

Imagine you are a U.S. tourist planning a trip to Canada. On Monday, the nominal exchange rate is quoted as 1 USD = 1.35 CAD. This means for every U.S. dollar you convert, you receive 1.35 Canadian dollars.

You decide to wait until Friday to exchange your money, hoping for a more favorable rate. By Friday, the nominal exchange rate has changed to 1 USD = 1.38 CAD.

Here's how the change in the nominal exchange rate impacts your purchasing power:

1. Monday's rate: If you exchanged $1,000 USD, you would receive (1,000 \text{ USD} \times 1.35 \text{ CAD/USD} = 1,350 \text{ CAD}).
2. Friday's rate: If you exchange $1,000 USD now, you receive (1,000 \text{ USD} \times 1.38 \text{ CAD/USD} = 1,380 \text{ CAD}).

In this scenario, the U.S. dollar has experienced an appreciation against the Canadian dollar, making your U.S. dollars worth more in Canada. This allows you to purchase more goods and services or simply have more Canadian dollars for your trip, demonstrating the direct effect of a nominal exchange rate on real-world spending power in another country.

Practical Applications

Nominal exchange rates are fundamental to nearly all international financial transactions and economic analysis. They are the benchmark for currency conversion in everyday activities, from international remittances to online shopping across borders. Businesses engaged in importing and exporting rely heavily on nominal exchange rates to price their goods, manage costs, and forecast revenues. A favorable nominal exchange rate can boost export competitiveness or reduce import costs, influencing a company's profitability and strategic decisions.

Central bank policies often aim to influence nominal exchange rates as part of broader monetary policy goals. For instance, central banks may buy or sell foreign currencies in the open market to strengthen or weaken their domestic currency. The Federal Reserve Bank of New York, for example, conducts foreign exchange operations as directed by the Federal Open Market Committee or the U.S. Treasury, to counter disorderly market conditions or to signal policy intentions. These i³nterventions directly affect nominal exchange rates by altering supply and demand dynamics in the foreign exchange market. Furthermore, economists and policymakers use nominal exchange rate data, often collected and published by organizations like the International Monetary Fund, to analyze global economic trends, trade imbalances, and capital flows.

Lim²itations and Criticisms

While nominal exchange rates provide an immediate conversion rate between two currencies, they have significant limitations, particularly when used to assess the relative purchasing power or competitiveness between countries. The primary criticism is that they do not account for differences in price levels or inflation between the two nations. This means a seemingly favorable nominal exchange rate might not translate into a real advantage if prices for goods and services are significantly higher in the foreign country. For example, if the U.S. dollar strengthens against the Euro, making European goods cheaper in dollar terms, this benefit can be offset if Europe experiences higher inflation, eroding the real purchasing power gain.

Academics and policymakers often point out that nominal exchange rates can be volatile and may not always reflect underlying economic fundamentals. Short-term movements in nominal exchange rates can be influenced by speculative activities, news events, or short-term shifts in interest rates, rather than solely by productivity or price differentials. This ca¹n lead to situations where a currency appears overvalued or undervalued based on its nominal rate, creating trade imbalances or distorting investment signals. The theory of purchasing power parity (PPP) attempts to address this limitation by suggesting that, in the long run, nominal exchange rates should adjust so that an identical basket of goods costs the same in two different countries. However, empirical studies often show persistent deviations from PPP, indicating that nominal exchange rates do not always fully reflect relative price levels.

Nominal Exchange Rates vs. Real Exchange Rates

The distinction between nominal exchange rates and real exchange rates is crucial in international economics. A nominal exchange rate, as discussed, is simply the stated price of one currency in terms of another, without adjustment for price levels. It tells you how many units of foreign currency you can get for one unit of your domestic currency.

In contrast, the real exchange rate adjusts the nominal exchange rate to account for differences in price levels between two countries. It aims to measure how much goods and services in the domestic country can be exchanged for goods and services in a foreign country. The real exchange rate provides a more accurate picture of a country's international competitiveness and the relative cost of living. If the real exchange rate appreciates, it means domestic goods are becoming more expensive relative to foreign goods, while a depreciation means domestic goods are becoming cheaper. The nominal exchange rate is the observable market rate, while the real exchange rate offers a more economic assessment of purchasing power, often used by economists to determine if a currency is undervalued or overvalued based on the purchasing power parity principle.

FAQs

What causes nominal exchange rates to change?

Nominal exchange rates are influenced by a multitude of factors, including differences in interest rates between countries, inflation differentials, economic performance, political stability, and market sentiment or speculation. Any event that shifts the supply or demand for a currency in the foreign exchange market can cause its nominal exchange rate to fluctuate.

How do central banks influence nominal exchange rates?

Central banks can influence nominal exchange rates through various tools, primarily monetary policy adjustments like changing interest rates. Higher interest rates can attract foreign capital, increasing demand for the domestic currency and causing it to appreciate. They can also directly intervene in the foreign exchange market by buying or selling foreign currencies to influence the domestic currency's value.

Are nominal exchange rates always floating?

No. While many major currencies today operate under a floating exchange rate system where market forces largely determine their values, some countries maintain a fixed exchange rate by pegging their currency to another major currency or a basket of currencies. Historically, systems like the Bretton Woods agreement also enforced fixed nominal exchange rates.