11.2 Exchange Rate

Chapter 11.2: Exchange Rates

11.2.1 Measurement of Exchange Rates

Nominal Exchange Rate

• The nominal exchange rate refers to the price of one currency in terms of another.

• For example, if 1 USD = 135 NPR, then the nominal exchange rate is 135.

• It does not account for differences in price levels or inflation between countries.

• It is the rate commonly quoted in foreign exchange markets.

Real Exchange Rate

• The real exchange rate adjusts the nominal rate by accounting for inflation differences between two countries.

• It reflects the true purchasing power of a currency relative to another.

• Formula:
  Real Exchange Rate = (Nominal Exchange Rate × Foreign Price Level) ÷ Domestic Price Level

• If the real exchange rate increases, domestic goods become more expensive relative to foreign goods, potentially reducing exports.

Trade-Weighted Exchange Rate (Effective Exchange Rate Index)

• A trade-weighted exchange rate is an index that shows the average value of a currency relative to the currencies of its major trading partners.

• Each currency in the basket is weighted according to the proportion of trade with that country.

• A rise in the index indicates an appreciation, and a fall indicates a depreciation.

• It is more comprehensive than bilateral exchange rates, giving a better picture of overall competitiveness.

11.2.2 Determination of Exchange Rates under Fixed and Managed Systems

Fixed Exchange Rate System

• In a fixed system, a country’s currency is pegged to another currency or a basket of currencies.

• The government or central bank maintains the rate through intervention—buying or selling foreign reserves.

• Example: If a country fixes its currency at 1 USD = 100 units of its currency, the central bank must maintain this rate.

• To defend the fixed rate, central banks may:

• Buy or sell their own currency in the forex market.

• Use interest rate adjustments to influence demand and supply.

• Impose foreign exchange controls.

Managed Exchange Rate System (Dirty Float)

• This system lies between fixed and floating exchange rates.

• The exchange rate is primarily determined by market forces but the central bank intervenes occasionally.

• Interventions are made to stabilize the currency or achieve macroeconomic goals such as inflation targeting or export competitiveness.

Floating Exchange Rate System

• Under this system, exchange rates are determined purely by supply and demand in the foreign exchange market.

• No direct intervention from the central bank.

• Factors affecting floating rates:

• Interest rate differentials

• Inflation rates

• Political and economic stability

• Speculation

11.2.3 Distinction Between Revaluation and Devaluation (Fixed Systems)

Devaluation

• A deliberate reduction in the value of a currency under a fixed exchange rate system.

• Done by the central bank or monetary authority.

• Makes exports cheaper and more competitive, but makes imports more expensive.

• May lead to imported inflation.

Revaluation

• An intentional increase in the value of a currency under a fixed system.

• Makes imports cheaper, reducing inflationary pressure.

• However, exports become more expensive, possibly hurting domestic industries.

Note: Revaluation and devaluation apply only to fixed or managed systems. In floating systems, currency values change through appreciation and depreciation.

11.2.4 Changes in Exchange Rates Under Different Systems

In Floating Systems

• Appreciation: An increase in the value of a currency due to higher demand or reduced supply.

• Causes: High interest rates, increased exports, capital inflows, or low inflation.

• Effects: Imports become cheaper, exports become more expensive.

• Depreciation: A decrease in the value of a currency due to reduced demand or increased supply.

• Causes: Lower interest rates, rising imports, political instability.

• Effects: Exports become cheaper, imports more expensive, which may cause inflation.

In Fixed/Managed Systems

• Changes are made by policy decisions rather than market forces.

• Central banks intervene to maintain target values or ranges.

• Frequent intervention may lead to depletion of foreign reserves or currency crises if mismanaged.

11.2.5 Effects of Changing Exchange Rates on the External Economy

Marshall-Lerner Condition

• States that a depreciation will improve the trade balance only if the sum of price elasticities of demand for exports and imports is greater than 1.

• If the condition is not met, depreciation may worsen the trade deficit.

• In the short run, demand tends to be inelastic, so the balance may deteriorate first before improving.

The J-Curve Effect

• Describes the short-term and long-term effects of depreciation on the current account.

• Initially, the current account may worsen because:

• Import contracts are fixed.

• Demand for exports/imports takes time to adjust.

• Over time, as quantity demanded adjusts and elasticities increase, the trade balance improves.

• The curve tracing this trend over time resembles the letter “J”.

Key Diagrams to Include

• Nominal vs. Real Exchange Rate (with inflation impact)

• Trade-weighted exchange rate chart

• Fixed vs. floating exchange rate mechanisms

• J-curve diagram

• Marshall-Lerner graphical interpretation

Conclusion

Understanding exchange rates is essential for grasping how economies interact in global trade. Changes in exchange rates influence inflation, trade balances, economic growth, and competitiveness. Policymakers often face the challenge of balancing exchange rate stability with other macroeconomic objectives.