Currency exchange rates can be "nominal" meaning that the rate is set in the marketplace, primarily on the world foreign exchange market, or "real" meaning the corrected nominal rate, adjusted for inflation.

While nominal rates can be easily accessed by reviewing forex market pricing, real exchange rates must be computed.

For example, if a country has an inflation rate of 5% and the country of the counter currency has an inflation rate of 2%, the first country's currency would have a real exchange rate 3% higher than the second country's, with the nominal rate unchanged.

The Japanese Yen's Value Reflects Inflation

Higher prices typically affect real exchange rates positively because as prices rise, many central banks raise interest rates in order to counter inflation. This tends to make the currency appreciate.

An example of how a government allows its currency to reflect inflation and stabilize under market conditions is Japan. In Japan, prices have been allowed to float upwards due to inflation without adjusting or revaluing the currency.

If the Japanese Yen is trading at 100 Yen to one U.S. Dollar, and a new suit costs ¥20,000, while the price may appear high in term of the amount of Yen, the suit actually only costs $200 at that exchange rate.

Nevertheless, the price of one item is an oversimplification. One needs to also take into account the fact that a Japanese worker makes ¥3000 per hour in order to accurately assess the Yen's buying power.

If prices increase and wages remain the same, this will most likely adversely affect the economy since the real wages of the worker decline in buying power.

Real Exchange Rate Definitions

The above example is an illustration of one of the first of two groups of definitions for the real exchange rate which has to do with purchasing power parity.

According to the purchasing power parity definition, the real exchange rate is defined by the nominal exchange rate adjusted by the ratio of the foreign price level to the domestic price level for a particular good or a basket of goods.

The other definition for the real exchange rate has to do with tradable and non tradable goods.

The way it is defined is by taking the relative prices of tradable and non tradable goods to make up an indicator of the country's level of competitiveness in foreign trade.

The reasoning behind this definition is that the cost differential between the two countries is directly related to the relative price structures in both economies.

The Effective Exchange Rate

Also known as the Trade Weighted Exchange Rate, this rate consists of a multilateral exchange rate which is made up of a weighted average of exchange rates of both domestic and foreign currencies, with the weight for each country equal to its share in trade.

The effective exchange rate measures the average price of a domestic good relative to the price of goods of its foreign trading partners, using each country's share of trade as the weighting for that country.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.