Currency Rates Reflect Inherent Volatility of Foreign Exchange Market

Simply defined, currency rates are the rates at which two different currencies of two different nations get exchanged. The rate at which these currencies get exchanged call currency exchange rate or foreign currency rate. Currencies can be free-floating or fixed. If it is free floating, the currency exchange rate can be different against other currencies and is decided by the market forces of supply and demand. The foreign currency rate for such currencies is likely to change almost constantly as being quoted on financial markets. Such currency exchange rate is mostly quoted by banks across the world. On the other hand, a movable or that which can be accommodated is called peg system. In this system, currency rates are fixed but in this system, they have the provision for the devaluation of a currency.

Another type of currency rates is that of real exchange rate also called RER. This rate is actually the real purchasing power of two countries which are relative to each other. These rates are determined by the GDP deflater measurement of the price level in domestic and foreign countries. This level is set randomly equal to 1 in a specific base year. Hence, it is because of this random setting of the RER based on the base year, the changes that may occur in RER are informative and relative to a unit of GDP in the foreign country in terms of GDP units of the domestic country. The reason why RER is constantly changing is because all goods are not freely available to all the citizens of the world. For example, if an American is purchasing the same basket of goods as that of Canadian, purchasing power parity for the GDP deflaters would be maintained, but since this is not possible, real currency rates or real currency exchange rate cannot be the constant and one.