Every day we see in the newspapers that the US Dollar has gained/lost again the Japanese Yen, the Euro has gained all currencies etc. We may wonder what it all really means. It is a good idea therefore to how the mechanism of exchange rates operates.
The exchange rate is the value at which any given currency can be traded against another. In the foreign exchange market, if one US dollar is worth 110 Japanese Yen or 50 Indian Rupees, then those numbers are the exchange rate of the greenback against the specific currencies.
Basically, we can say that the exchange rate is an equivalent value and works as a factor for currency conversion.
There are both nominal and real exchange rates.
Nominal exchange rates are established on ‘forex markets’ or by the country’s central bank. These are the rates which we see almost every day in the newspapers.
Real exchange rates are the nominal rate adjusted against inflation. Depending upon the difference in inflation rates between countries, the real exchange value between their currencies will be different (lower or higher than the nominal rate).
In many countries, which have been subject to political upheavals, war or economic downturns, lack markets exist for currency conversion. As an example, if the USD is traded against the Pakistani Rupee, at least 25% extra can be obtained in the black market there. In some African countries and in Eastern Europe, a similar situation prevailed a few years before.
The basic value of currencies also depends upon the classic economic theory of demand and supply which translates, in trade scenarios, as Export and Import. If there is more demand in a country for US Dollars(in private business enterprises there may be a need to pay to US agencies/clients towards purchasing of commodities/services etc),then the exchange rate of the dollar against that currency will be favorable to the greenback. The exchange rate thus can vary depending on the demand situation. In such a case, the rate is called as flexible. To prevent too much sliding down in the value of their currency, the central bank there may intervene and invest in dollars. To prevent a worsening scenario for their currency, the central bank can also publish a fixed exchange rate.
The difference between exports and imports of a country is called as the ‘balance in trade’. This can be a surplus or a deficit. This trade balance affects the exchange rates of their currency. Obviously, a trade deficit indicates a weakening of the currency.