Inside the borders of a country, goods and services are traded with that nation’s currency. However, to trade goods and services with other countries, foreign currencies are needed. Foreign exchange rate is the amount of home currency units that are to be paid to obtain a single unit of a foreign currency. To put it simply, an exchange rate is the relative price of two currencies.
In economic literature, there are two different concepts of foreign exchange rate. The main difference between these two concepts are the usuage of inflation in their structure.
Nominal Exchange Rate refers to the rate with which a person can exchange the currency of a certain country with another one. This rate is determined by the interactions of the demand and supply side, along with the exchange rate system.
Real Exchange Rate shows the competitiveness of the goods made inside a country in contrast to the goods produced in the comparing country. In other words, real exchange rate is determined from deviding the price of a good (in terms of the home country’s currency) to the price of the same good produced inside the country.
There are two main systems of exchange rates: In a floating exchange rate system, rates are determined by market forces. As you see, this is a lot like the real exhange rate. In fixed exchange rate systems, however, the government and the central bank of a country intervene to keep the exchange rate at a certain point.
The impact of exchange rate on production
A high exchange rate, results in lower prices for exported goods while enhancing the expenses for imported goods. Hence, demand for domestic goods and services will increase.
Industries importing raw material, however, are extremely dependent on the exchange rate, and an increase in the exhange rate will increase the production costs.
The impact of exchange rate on exports
Theoretically, an increase in exchange rates, will decrease the exporting goods and services in contrast to global prices, therefore increasing the competitiveness of domestic producers in the global market. Hence, the exports will experience a boost.
The impact of exchange rate on imports
If a rise happens in exchange rates, the price of foreign goods will increase for the domestic consumer, and as a result, the demand for domestic goods and services will increase. This declines the motivations for imports.