38. Exchange Rates

1. What is an Exchange Rate?

An exchange rate is the value of one country’s currency expressed in terms of another. It determines how much of one currency can be exchanged for another and is essential in international trade and finance.

• Direct quote: Domestic currency per unit of foreign currency.
  

• Indirect quote: Foreign currency per unit of domestic currency.

2. Trade-Weighted Exchange Rate

• This index measures the value of a country’s currency against a basket of other currencies.
  

• The basket is weighted according to the importance of trade with each country.
  

• Helps reflect how a currency performs globally rather than just against one other currency.

3. Real Effective Exchange Rate (REER)

• REER is the weighted average of a currency relative to a basket of others, adjusted for inflation differences.
  

• Formula:
  Real Exchange Rate =
  (Nominal Exchange Rate × Domestic Price Index) / Foreign Price Index

• A more accurate representation of competitiveness than nominal rates.

4. Types of Exchange Rate Regimes

a. Floating Exchange Rate

• Currency value is determined by market forces—supply and demand.
  

• There is no government or central bank intervention.
  

• Currency value fluctuates constantly based on economic conditions, trade flows, speculation, and interest rates.
  

Advantages:

• Automatic correction of balance of payments issues.
  

• Flexible response to economic shocks.
  

• Central banks can pursue independent monetary policies.
  

Disadvantages:

• Uncertainty for international traders and investors.
  

• Can lead to excessive volatility.

b. Fixed Exchange Rate

• Currency is pegged to another currency or a basket (e.g. USD, gold).
  

• Central bank actively maintains the pegged rate by buying/selling currency.
  

Historical Example:

• IMF System (Bretton Woods):
  

• Fixed currencies against USD (which was backed by gold).
  

• System collapsed in 1971 due to US inflation and deficit from Vietnam War.
  

Advantages:

• Exchange rate stability and certainty.
  

• Encourages investment and international trade.
  

• Imposes monetary discipline to control inflation.
  

Disadvantages:

• Requires large foreign exchange reserves.
  

• Difficult to maintain during economic shocks or trade imbalances.
  

• Restricts domestic monetary policy flexibility.

c. Managed Float (Dirty Float)

• Exchange rate is mostly determined by market forces, but central banks intervene to stabilize or guide its movement.
  

• Most major economies use this system.
  

• Balances the benefits of floating rates with the ability to correct extreme volatility.

5. Factors Affecting Currency Demand and Supply

a. Demand for Currency Increases When:

• Exports rise.
  

• Interest rates increase (attracting foreign investment).
  

• Foreign Direct Investment (FDI) inflows grow.
  

• Speculators expect the currency to appreciate.
  

• Lower inflation improves competitiveness.
  

b. Supply of Currency Increases When:

• Imports increase.
  

• Domestic investors invest abroad.
  

• Citizens buy foreign financial assets.
  

• Central bank policies increase money supply in the forex market.

6. Interest Rate and Exchange Rate Relationship

• Higher interest rates attract foreign investors seeking higher returns → increased demand for domestic currency → appreciation.
  

• Lower interest rates → reduced foreign investment → depreciation.
  

• Speculative capital flows driven by interest rate differentials are known as hot money flows.

7. Currency Movements in Floating Systems

a. Appreciation

• Value of domestic currency rises.
  

• Effects:
  

• Imports become cheaper.
  

• Exports become expensive abroad.
  

• May reduce net exports and GDP growth.
  

b. Depreciation

• Value of domestic currency falls.
  

• Effects:
  

• Exports become cheaper and more competitive.
  

• Imports become expensive.
  

• May increase net exports, aggregate demand, and GDP.
  

Elasticity Matters:
Impact depends on the price elasticity of demand for exports and imports.

8. Currency Changes in Fixed Systems

a. Revaluation

• Official increase in fixed exchange rate.
  

• Makes exports more expensive and imports cheaper.
  

b. Devaluation

• Official decrease in fixed exchange rate.
  

• Makes exports cheaper and imports more expensive.
  

These changes are usually made by the government or central bank for economic policy goals.

9. J-Curve Effect

• Describes the short-run and long-run effects of a depreciation on the balance of trade.
  

Stages:

1. Immediately after depreciation:

• • Value of imports increases (more expensive), while export volumes don’t rise instantly due to existing contracts.
    

  • Trade deficit worsens temporarily.

2. Over time:

• Exports become more competitive.
  

• Import volumes fall.
  

• Trade balance improves.
  

Graph Shape: The curve dips before rising, forming a “J”.

10. Reverse J-Curve Effect

• Occurs with appreciation or revaluation.
  

• Initially:
  

• Imports are cheaper → current account improves.
  

• Later:
  

• Exports become more expensive → fall in demand → current account deteriorates.
  

• Depends on the Marshall-Lerner condition (which relates to elasticity).

11. Advantages and Disadvantages of Each Exchange Rate System

12. Summary of Key Terms

• Nominal Exchange Rate: Market rate, unadjusted for inflation.
  

• Real Exchange Rate: Adjusted for inflation, reflects purchasing power.
  

• Hot Money: Speculative capital moving across borders based on expected returns.
  

• FDI: Investment in foreign businesses/assets.
  

• REER: Real Effective Exchange Rate.