What is an Exchange Rate?

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What is an Exchange Rate?

If you asked the 'Average Joe' what the exchange rate is, he would probably tell you "it's the amount of dollars (or euros, for example) you get to the pound". Whilst not the perfect definition, he is technically correct. Of course, most people only need to understand exchanges rates when they go on holiday. As an economist, you need to understand how they affect the balance of payments, the inflation rate and many other important macroeconomic objectives.

Unfortunately, our layman's definition of the exchange rate is not the only one. In this Learn It, we shall look at the different definitions of the exchange rate before we go on to investigate more important issues like how this exchange rate is determined.

This is the definition that most people understand when discussing the exchange rate. It is often referred to as the nominal exchange rate. This is defined as the rate at which one currency can be converted, or 'exchanged', into another currency.

The pound is currently worth about one and a half US dollars. One pound can be converted into one and a half dollars. This, therefore, is the exchange rate between the pound and the dollar. The table below gives you some of the exchange rates against the pound over the last 20 years:

Year German mark French franc The euro
1980 4.23 9.83
1981 4.56 10.94
1982 4.24 11.48
1983 3.87 11.55
1984 3.79 11.63
1985 3.78 11.55
1986 3.18 10.16
1987 2.94 9.84
1988 3.12 10.60
1989 3.08 10.45
1990 2.88 9.69
1991 2.93 9.95
1992 2.76 9.33
1993 2.48 8.50
1994 2.48 8.48
1995 2.26 7.87 1.19
1996 2.35 7.98 1.21
1997 2.84 9.56 1.45
1998 2.91 9.77 1.49
1999 2.97 9.97 1.52
2000* 3.24 10.86 1.66

* The exchange rate of the euro is based on the market rate on the 23rd August 2000. The rates for the German mark and French franc are based on their respective rates against the euro as of 1st January 1999 (which haven't changed) multiplied by the pound/euro exchange rate on the 23rd August 2000.

The figures for the euro only began in 1995. Pre-1999, these figures represent an average of the 11 countries that eventually joined the single currency.

As you can see, the pound was particularly strong in the early 80s, due to the effects of being a net exporter of oil for the first time. It was weak in the few years after the UK fell out of the Exchange Rate Mechanism (ERM), and then rose again from the summer of 1996 to its current high levels. There will be much discussion of the reasons for these changes in later Learn-Its.

The formal name for this measure of the exchange rate is the effective exchange rate. Most newspapers prefer to use the name 'trade weighted index', probably because it is a better description of the exchange rate itself.

This measure is an index series. The 'numbers' published have no units and the series is based on a base year, which is currently 1990 (although it could be any year). Changes in this 'number' can be used to measure percentage changes in the statistic on which the index series is based (in this case, the value of the pound). Like the Retail Price Index (RPI), which tries to reflect the average price level in the UK across thousands of goods and services, the trade weighted index is trying to give an idea of the average exchange rate across all the important currencies. The weights in the average reflect the fact that the UK does more trade with some countries than others (just like the weights in the RPI reflect the fact that some goods and services are more important than others).

The example below should help to explain. Assume that the UK only trade with three countries - the USA, France and Ireland. The table below shows how the nominal exchange rates have changed, but that the value of the weighted average depends on the importance of the countries in trading terms with the UK.

Country Weight Exchange rate (1998) Exchange rate (1999) % change over the year
USA 50% £1 = %1.50 £1 = %1.65 + 10%
France 40% £1 = 10 francs £1 = 11.5 francs + 15%
Ireland 10% £1 = 2 punts £1 = 1 punt -50%
TOTAL 100%

It should be noted that these exchange rates are not totally accurate. They were picked to make the arithmetic easy, as you will see.

In the example above, we can see that the pound rose fairly robustly against the dollar and franc over the year, but the pound fell drastically against the Irish punt. If we took a non-weighted, normal average, we would find that the pound fell overall against these three currencies:

The trade weighted index

In other words, each country has a weight of 33%. So, another way of working this out is the following:

The trade weighted index

What has happened here is that the large fall in the pound's exchange rate against the punt (the least important currency in terms of trade - hence the 10% weight) has outweighed the significant rise in the pound against the more important currencies (in terms of trade). This is why weights are used to reflect this importance. Look at the weighted average below:

The trade weighted index

In the example that has been constructed, if we assume that the base year is 1998, which is then given the 'number' 100, the 'number' given to the year 1999 is 106, because the weighted average has risen by 6%.

The overall rise in this 'trade weighted index' reflects the fact that the pound rose against the currencies that made up 90% of the 'importance' of this measure.

The diagram below shows what has happened to the real trade weighted index over the last 20 years:

The trade weighted index

This graph is only a sketch and uses the figures for yearly averages, but you still get a feel for the trends in the effective exchange rate over the last 20 years. It should be noted that, just like the RPI, the weights for this exchange rate do change over time. In the 70s, the weight for the USA was about a third, and the combined weight for the 15 EU countries was slightly more. The UK now trades much more with the EU than the USA. The weight for the USA is now nearer one-sixth and the weight for the 15 EU countries is about three-quarters!

It is of no surprise, therefore, that the trade weighted index measure of the pound tends to follow the pound's course with the euro rather than the dollar. The pound has lost around 8% of its value against the dollar over the last year. The pound has risen about 9% against the euro in the same time. The trade-weighted index has risen by about 4% over the year, showing that the influence of the euro is stronger than that of the dollar.