4.1.8 - exchange rates

• The exchange rate is the purchasing power of a currency in terms of what it can buy of other currencies.
• A fixed exchange rate has a value determined by the government compared to other currencies.
• Managed exchange rate systems combine the characteristics of fixed and floating exchange rate systems. The currency fluctuates, but it doesn’t float on a fully free market.
• Floating Exchange Rate System:

  • In a floating exchange rate system, the exchange rate is determined by supply and demand in the foreign exchange market.
  • Governments and central banks do not actively intervene to fix the rate, allowing it to fluctuate freely.
• Revaluation is an increase in the official exchange rate of a currency set by the government or central bank. It is a deliberate policy move to strengthen the currency's value.
• Appreciation refers to a natural increase in the value of a currency due to market forces, such as increased demand for the currency in the foreign exchange market.
• Devaluation is a deliberate policy action by a government or central bank to reduce the official exchange rate of its currency. This makes exports cheaper and imports more expensive.
• Depreciation occurs when a currency's value decreases in the foreign exchange market due to market forces, such as decreased demand for the currency.
• Impact of Changes in Exchange Rates:

  • Marshall-Lerner Condition
  • J Curve Effect
• Marshall-Lerner Condition: A depreciation of the domestic currency will improve the trade balance if the sum of price elasticities of demand for exports and imports is greater than 1.
• • J Curve Effect: In the short term, a depreciation may initially worsen the trade balance before improving it, as it takes time for demand elasticities to adjust.