Nominal exchange rate

Nominal exchange rate is defined as the price of the currency of one country expressed in the currency of another country, excluding inflation. However, after taking it into account we are talking about the real exchange rate.

For example, if the exchange rate is 1 EURO = 4 PLN, German citizens may exchange 1 EURO for 4 PLN on the world market. Similarly, a Pole can exchange 4 PLN for 1 EURO.

Nominal exchange rate and market stability

In order to improve the stability of imports and exports, the determined exchange rate has been adapted to the needs of a custom made-basket of currencies than SDR, which may exceed the determination of the exchange rate against one currency or SDR. The main disadvantage of designing exchange rate patterns is their complexity and high data requirements.

"In a general equilibrium context, exchange rate stability alone cannot guarantee overall external and domestic stability. however, exchange rate stability affects broad macroeconomic stability, that is, the stability of the fundamental macroeconomics." (Mr. Zubair Iqbal, Mr. S. Nuri Erbas, 1997, p. 3).

SDR (Special Drawing Rights) is an international currency unit with a non-cash character. It is used only by:

1. Central banks of states
2. Financial institutions

Nominal effective exchange rate

"A nominal effective exchange rate index is the ratio of an index of a currency's period-average exchange rate to a weighted geometric average of exchange rates for currencies of selected countries and the euro area." (World Bank, 2011, p. 257)

The nominal exchange rate during hyperinflation

"Hyperinflation - the high inflation that arises when a government turns to the printing press to pay for large amounts of government spending." (N. Gregory Mankiw, Mark P. Taylor, 2006, p. 652).

"When the supply of money starts growing quickly, the price level also takes off and [..] mark depreciates. When the money supply stabilizes, so does the price level and the exchange rate. [...] It leaves no doubt that there is a fundamental link among money, prices and the nominal exchange rate." (N. Gregory Mankiw, Mark P. Taylor, 2006, p. 652).

The theory of purchasing power parity

Under "the theory of purchasing power parity, the nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries. A key implication of this theory is that nominal exchange rates change when price level change. [...], the price level in any country adjusts to bring the quantity of money supplied and the quantity of money demanded into balance. Because the nominal exchange rate depends on the price levels, it also depends on the money supply and money demand in each country." (N. Gregory Mankiw, Mark P. Taylor,2006, p. 651).

"When a central bank in any country increases the money supply and causes the price level to rise, it also causes that country's currency to depreciate relative to other currencies in the world." (N. Gregory Mankiw, Mark P. Taylor,2006, p. 651-652).

Examples of Nominal exchange rate

• The nominal exchange rate between the United States and the Euro is the number of US Dollars (USD) it takes to purchase one Euro (EUR). For example, if one Euro is equal to 1.2 USD, then the nominal exchange rate is 1.2 USD/EUR.
• The nominal exchange rate between the United Kingdom and the Japanese Yen is the number of British Pounds (GBP) it takes to purchase one Japanese Yen (JPY). For example, if one Japanese Yen is equal to 0.008 GBP, then the nominal exchange rate is 0.008 GBP/JPY.
• The nominal exchange rate between the Chinese Yuan and the Swiss Franc is the number of Chinese Yuan (CNY) it takes to purchase one Swiss Franc (CHF). For example, if one Swiss Franc is equal to 6.7 CNY, then the nominal exchange rate is 6.7 CNY/CHF.

Advantages of Nominal exchange rate

Nominal exchange rate has several advantages:

• It is a simple and straightforward way of measuring the exchange rate between two currencies. It also provides a benchmark for other exchange rates.
• It is also useful for international trade and investment, as it allows for comparison of costs and profits between different countries.
• It is also useful for studying the relationship between the currencies of different countries, as it provides information on their relative values.
• It is also useful for analyzing the effects of government policies on the exchange rate, as it allows for direct comparison between different countries.
• It is also helpful to economists in understanding the macroeconomic dynamics of different countries.

Limitations of Nominal exchange rate

Nominal exchange rate is a useful tool for determining the relative value of two currencies, however it does have some limitations. These limitations include:

• It does not take into account inflation rates of the two countries, meaning that it does not reflect the true purchasing power of the currencies.
• It does not account for other economic factors such as taxes and tariffs, which can affect the cost of goods and services.
• It does not reflect the relative demand for the currencies.
• It does not take into account factors such as political stability, government debt, and economic growth which can have a significant impact on currency values.
• It does not reflect the cost of capital in the two countries or the cost of borrowing in either currency.

Other approaches related to Nominal exchange rate

Nominal exchange rate is just one of the ways in which currency rates can be measured. Other approaches to exchange rate measurement include the following:

• Purchasing Power Parity (PPP): This approach looks at the relative purchasing power of two currencies and calculates the exchange rate based on the differences in the cost of goods and services in each country.
• Interest Rate Parity: This approach looks at the differences in interest rates between two countries and determines the exchange rate between them.
• Balance of Payments: This approach looks at the difference between what a country is exporting and what it is importing, and adjusts the exchange rate accordingly.
• Relative Price Levels: This approach looks at the relative prices of goods and services in two countries and adjusts the exchange rate accordingly.

In sum, there are several approaches to measuring currency exchange rates, with the Nominal exchange rate being just one of them. Each approach takes into account different factors and can lead to different exchange rate values.

Nominal exchange rate — recommended articles

Foreign trade multiplier — Global demand — Exchange rate and inflation — Interest rate parity — Net Borrower — Country risk — Okuns law — Economic climate — Currency Convertibility

References

• Iqbal Z., Erbas S. N. (1997), External Stability Under Alternative Nominal Exchange Rate Anchors: An Application to the GGC Countries, International Monetary Fund, Washington
• Mankiw N. G., Taylor M. P. (2006), Economics, Thomson Learning, Bath, UK
• World Bank (2011), World Development Indicators 2011,the International Bank, Washington

Author: Łukasz Gil