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Exchange Rates

Exchange rates are needed for international transactions to occur because it is necessary to transact in the same currency. There are two types of exchange rates: nominal and real exchange rates. Nominal exchange rates show how much foreign currency can be exchanged for a unit of domestic currency or vice versa (the number that you would see at a money changer). Real exchange rates represents the number of goods that can be bought in another country relative to your own country; that is to say, it takes into account the ratio of price levels between two countries. 

The relationship between net exports and real exchange rates is important to the topic of exchange rates. When the real exchange rate is high, then the domestic relative price of goods is higher than the relative price of goods overseas. When this occurs, a country will import goods from other countries because foreign goods will be cheaper. This also causes net exports to decrease. The opposite will therefore occur when the real exchange rate decreases.

With exchange rates, there are three different types of regimes: floating, pegged, and fixed rates. A floating exchange rates allows the exchange rate to be completely determined by market forces - demand and supply of the currency. A fixed exchange rate is where the government sets a pre-determined exchange rate and then uses its foreign reserve and monetary policy to maintain it. A pegged exchange is where an economy will set it's currency at a fixed exchange rate to another foreign currency; it will move in line with the currency it has pegged itself to. For example, the Chinese RMB is pegged to the US dollar. 

The exchange rate and exchange rate behaviour provide insight to understanding how foreign exchange is conduced. Present exchange rates reflect the predicted values of future variables.

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