Cambridge International as and a level Economics Ebook

real 
eff ective exchange rate
takes price changes as well as 
exchange rate changes into account to assess changes 
in the competitiveness of a country’s products in global 
markets. A fall in a country’s foreign exchange rate would 
be expected to make its exports more price competitive. 
If, however, the country is experiencing a relatively high 
infl ation rate, export prices may actually be increasing. 
A real exchange rate shows the price of domestic products 
in terms of foreign products:
The real 
exchange 
rate
nom
l exchange rate domestic pr
=
×
ina
iice index
foreign exchange rate
Th
e real exchange rate may rise as a result of an 
appreciation or an increase in the country’s relative 
infl ation rate.
Trade weighted exchange rate: 
the price of one currency 
against a basket of currencies.
Real eff ective exchange rate: 
a currency’s value in terms 
of its real purchasing power.
KEY TERMS
TOP TIP
Follow changes in your country’s exchange rate, noting 
causes and eff ects.
Remember there is a diff erence between the external 
and internal value of a currency. The exchange rate 
shows the external value and the price level shows the 
internal value.
The determination of foreign exchange rates
Floating exchange rates
A 
fl oating exchange rate
is one determined by market 
forces. Currencies are bought and sold on the foreign 
exchange market. Th
is market does not exist in a single 
location but is made up of fi nancial institutions that 
buy and sell foreign currency on behalf of private and 
business customers. Large values of currencies are 
bought and sold on any particular day. Th
e price of 
the currency is determined by the relative strengths 
of the demand for and supply of the currency. Th
ere 
are various reasons why currency traders will buy 
the domestic currency. Th
ese include enabling their 
customers to:
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