Foreign Exchange Rate Systems and Parity Relationships

There are two major categories of exchange rate systems:

  • Flexible or Floating – laws of supply and demand determine currency value
  • Fixed – the government pegs the exchange rate value and actively participates in currency markets to maintain the value

The market quotes nominal exchange rates whereby a unit of once currency can be exchanged for some amount of another currency.  The real exchange rate reflects the price level differentials of the currencies being exchanged.

Real Exchange Rate Foreign/US =

Nominal Exchange Rate Foreign/US x (Price Level US / Price Level Foreign)