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The exchange rate is the price of one currency in terms of another. The nominal exchange rate is the quoted market price; the real exchange rate adjusts for relative price levels, measuring international competitiveness. A currency appreciates when it buys more foreign currency (domestic goods become more expensive to foreigners, hurting exports) and depreciates when it buys less (boosting exports but raising import costs). Purchasing power parity (PPP) predicts that exchange rates equalize the price of identical goods across countries in the long run. Exchange rates are determined by trade flows, interest rate differentials, inflation expectations, and speculation.
Compute a real exchange rate from nominal rate and price level data. Analyze what happens to US net exports when the dollar appreciates 10%. Examine the Big Mac Index as an illustration of PPP.
You've studied comparative advantage and know that countries benefit from specializing and trading. Exchange rates are the mechanism that makes this work in practice — they determine the relative prices of goods across national borders. The nominal exchange rate is simply the market price of one currency in terms of another: if 1 USD = 0.93 EUR, the dollar has a nominal exchange rate of 0.93 against the euro. Like any price, this is determined by supply and demand — the demand for dollars comes from foreigners buying US goods, services, and assets; the supply comes from Americans buying foreign goods, services, and assets.
The real exchange rate goes one step deeper: it adjusts the nominal rate for relative price levels. Real exchange rate = (Nominal rate × Domestic price level) / Foreign price level. This measures actual international competitiveness — whether your goods are genuinely cheap or expensive to foreign buyers after accounting for inflation differences. If US inflation is 5% while European inflation is 2%, the dollar will buy fewer euros in real terms even if the nominal rate is unchanged, because US goods have become relatively more expensive. This is why economists focus on real exchange rates when analyzing trade flows: a nominal appreciation that merely reflects higher domestic inflation doesn't hurt competitiveness, but a real appreciation does.
Purchasing power parity (PPP) is the long-run anchor for exchange rates. The Big Mac Index — comparing McDonald's burger prices across countries — is a famous illustration: if a Big Mac costs $5 in the US and €4 in Germany, PPP implies the exchange rate should be 0.80 €/$ in the long run. If the dollar is currently stronger, it's "overvalued" relative to PPP. The logic is arbitrage: if identical goods are cheaper in one country, demand for that country's currency should rise until prices equalize. In practice, PPP holds poorly in the short run — financial flows, speculation, and sticky prices dominate exchange rate movements over months or even years. But over decades, currencies tend to drift toward PPP levels, making it useful for long-run forecasting and for comparing living standards across countries.
Short-run exchange rate determination is driven by interest rate differentials and expectations. Higher interest rates attract capital inflows — foreign investors sell their currency to buy yours in order to invest in your higher-yielding assets. This increased demand appreciates your currency. The uncovered interest parity condition formalizes this: the expected return on domestic and foreign assets should be equal, implying that a country with higher interest rates should expect its currency to depreciate — otherwise there would be riskless profit opportunities. In practice, exchange rates are among the hardest financial variables to forecast, and the policy tradeoffs are genuine: a strong currency benefits import-reliant industries and reduces inflation via cheaper imports, while hurting exporters and domestic manufacturers.