Nominal, real and effective exchange rates
Nominal exchange rate
The exchange rate that prevails at a given date is known as the nominal exchange rate; it is the amount of US dollars that will be obtained for one pound in the foreign exchange market.Similarly, if the Swiss franc to pound quotation is 2.50CHF/￡1, this is again a nominal exchange-rate quotation.The nominal exchange rate is merely the price of one currency in terms of another with no reference made to what this means in terms of purchasing power of goods/services.It is usually presented in index form; if at the base period the exchange rate is $1.60/￡1 and one period later the exchange rate is $1.80/￡1 the nominal exchange-rate index of the pound against the dollar will change from the base period value of 100 to 112.5.A depreciation or appreciation of the nominal exchange rate does not necessarily imply that the country has become more or less competitive on international markets; for such a measure we have to look at the real exchange rate.
Real exchange rate
The real exchange rate is the nominal exchange rate adjusted for relative prices between the countries under consideration.It is normally expressed in index from algebraically as:
Here Sr stands for the index of the real exchange rate, S for the nominal exchange rate (foreign currency units per unit of domestic currency)in index form, P for the index of the domestic price level, and P* for the index of the foreign price level.
Effective exchange rate
Since most countries of the world do not conduct all their trade with a single foreign country, policy-makers are not so much concerned with what is happening to their exchange rate against a single foreign currency as what is happening to it against a basket of foreign currencies with which the country trades.The effective rate is a measure of whether or not the currency is appreciating or depreciating against a weighed basket of foreign currencies.