An exchange rate is the price of one currency in terms of another — pounds per dollar, dollars per euro, and so on. It is one of the most visible relative prices in an open economy, yet also one of the easiest to over-interpret. This explainer separates spot moves, inflation-adjusted (real) exchange rates, and purchasing power parity (PPP), with links to official data.
Nominal exchange rates
In floating regimes like those of sterling and the US dollar in normal times, the exchange rate clears a foreign-exchange market influenced by trade flows, interest-rate differentials, risk appetite, and expectations. News about monetary policy, fiscal credibility, or global risk can move currencies quickly. A stronger currency makes imports cheaper in domestic currency and makes exports more expensive for foreign buyers, other things equal.
Quotes have two directions. Saying “the pound strengthened” usually means one pound buys more dollars (or another foreign currency) than before. Always check the quotation convention before comparing charts.
Real exchange rates
Inflation differentials matter for competitiveness. If UK prices rise faster than US prices while the nominal pound–dollar rate is unchanged, UK goods become relatively dearer — a real appreciation. Broadly:
real exchange rate ≈ nominal rate × (domestic prices / foreign prices)
(Exact formulae depend on how the nominal rate is defined.) Real effective exchange rates (REERs) average bilateral rates against a basket of trading partners, weighted by trade shares, and adjust for prices or costs. The IMF, Bank for International Settlements, and national sources publish REER indices.
Purchasing power parity
PPP is the idea that, in the long run, exchange rates should move toward levels that equalise the purchasing power of currencies for a comparable basket of goods. Absolute PPP says the exchange rate equals the ratio of price levels. Relative PPP focuses on changes: inflation differentials should match depreciation or appreciation over time.
- Why PPP fails in the short run: many goods are non-tradable (haircuts, housing services), trade costs and barriers exist, and financial flows dominate short-term FX.
- Why PPP still helps: over long horizons, large inflation gaps tend to show up in currency paths; PPP-based conversions improve living-standard comparisons versus market exchange rates alone.
Market exchange rates are the right tool for trading financial assets today. PPP rates are often better for comparing real incomes across countries.
Big Macs, ICP, and serious PPP data
Journalistic PPP illustrations (like burger indexes) are memorable teaching devices, not official statistics. For research-grade comparisons, the World Bank’s International Comparison Program (ICP) and related Penn World Table work estimate PPPs for GDP and consumption. The IMF and OECD also publish PPP conversion factors used in international accounts.
If a basket costs £100 in the UK and $150 in the US, a crude absolute-PPP dollar-per-pound rate would be 1.5. Actual market rates can differ for years. Use OECD or World Bank PPP factors for real analysis — not this toy basket.
Policy and the UK–US lens
Neither the Fed nor the BoE targets a level for the exchange rate under their standard floating regimes, but both watch FX as part of financial conditions and imported inflation. A sterling depreciation can raise UK CPI via import prices; a dollar move alters US import costs and global commodity invoices often priced in dollars.
Trade balances interact with capital flows: a current-account deficit must be matched by net capital inflows. Exchange-rate adjustment is one channel among many. See international trade, inflation, and glossary exchange rate and current account.
Interest rates and the FX short run
Uncovered interest parity — a benchmark theory — says that high-interest currencies should be expected to depreciate so that expected returns equalise across currencies after exchange-rate changes. In practice, returns are risky and expectations are noisy, so carry trades can persist for long stretches and then reverse abruptly. For a reader of headlines, the useful takeaway is narrower: unexpected monetary tightening often strengthens a currency in the short run by attracting capital, while unexpected easing often does the opposite, other things equal.
Risk-off episodes can dominate that logic. The US dollar frequently appreciates when global investors seek liquidity, even if US growth news is mixed. Sterling, as a smaller reserve currency, can move sharply with UK-specific fiscal or political news as well as with global risk. Separating “local story” from “global dollar story” is a practical first filter.
Terms of trade and imported inflation
Energy and commodity prices interact with exchange rates. A country that imports energy will feel a stronger domestic inflation impulse when oil rises in dollars and its currency is weak at the same time. That is one reason UK inflation discussions after energy shocks often mention sterling alongside wholesale gas prices. The US, as a large producer and as the issuer of the invoicing currency, experiences a different mix of channels — still important, but not identical.
Pass-through from FX to consumer prices is usually partial and lagged. Retailers may absorb some cost changes, contracts may be sticky, and distribution margins matter. Claiming that a 10% depreciation raises CPI by 10% is almost always wrong; claiming it does nothing is also wrong. Empirical pass-through estimates live in central-bank research, not in slogans.