by Madhusoodanan K.P

Created on: December 12, 2009   Last Updated: December 15, 2009

We see almost daily in the newspapers, foreign exchange rates published; with statements like the US Dollar falls against the Euro, the Japanese yen gains value against the dollar etc.And very often we may not quite understand what is going on. The today's exchange rates column in the papers list various currencies and mention their value against the US Dollar. 

Assuming we are traveling to Europe and want some Euros in cash (to pay for a coffee, taxi fares etc), we go to a bank. Surprisingly we will find that the exchange rates that we have seen in the papers are not the ones that we will get at the bank. We might wonder what is going on. Let us see how exchange rates work. 

An exchange rate is the value at which any given currency can be traded against another. In the foreign exchange market, if one US dollar is worth 110 Japanese Yen or 50 Indian Rupees, then those numbers are the exchange rates of the greenback against the specific currencies. 

Basically, the exchange rate is an equivalent value and works as a conversion factor. 

There are both nominal and real exchange rates. 

Nominal exchange rates are established on 'forex markets' or by the country's central bank. These are the rates which we see daily in the newspapers. 

Real exchange rates are the nominal rate adjusted against inflation. Depending upon the difference in inflation rates between countries, the real exchange value between their currencies will be different (lower or higher than the nominal rate). 

In many countries, which have been subject to political upheavals, war or economic downturns, black markets exist for currency conversion. As an example, if the USD is traded against the Pakistani Rupee, at least 25% extra can be obtained in the black market there. In some African countries and in Eastern Europe, a similar situation prevailed a few years before. 

The basic value of currencies and their exchange rates also depend upon the classic economic theory of demand and supply which roughly translates, in trade scenarios, as Export and Import. If there is more demand in a country for US Dollars( private business enterprises there may need to pay to US agencies/clients towards purchasing of commodities/services etc),then the exchange rate of the dollar against that currency will be favorable to the greenback. The exchange rate of USD with respect to that currency, thus, can vary depending on the demand situation. In such a case, the rate is called

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