Chapter 28 : Exchange rates

• Determination of exchange rates:

  • Floating: value determined by supply and demand
  • Fixed: value determined by the government
  • Managed float: exchange rate floats but central bank buys and sells currencies to influence the rate
• Depreciation and appreciation:

  • Depreciation: value falls in a floating exchange rate system
  • Appreciation: value increases, allowing each pound to buy more dollars
• Factors underlying changes in exchange rates:

  • Inflation: lower inflation makes exports more competitive, increasing demand for the currency and causing appreciation
• Factors underlying changes in exchange rates:

  • Interest rates: higher rates attract investment, increasing demand for the currency and causing appreciation
• Factors underlying changes in exchange rates:

  • Government finances: high debt levels can cause currency depreciation as investors lose confidence
• Effects of changing exchange rates on the domestic and external economy:

  • Marshall-Lerner condition: devaluation improves balance of trade if export and import demand elasticities sum to 1 or more
• Definitions and measurement of exchange rates:

  • Nominal exchange rate: weight of one currency relative to another, not adjusted for inflation
  • Real exchange rate: exchange rate adjusted for inflation to reflect purchasing power
  • Trade-weighted exchange rate: weighted average of the exchange rate of the domestic currency relative to foreign currencies, where the weight of each currency is equal to the share in trade
• Devaluation and revaluation:

  • Devaluation: value officially lowered in a fixed exchange rate system
  • Revaluation: currency's value adjusted relative to a baseline like the price of gold or another currency
• Factors underlying changes in exchange rates:

  • Balance of payments: current account deficit leads to currency depreciation if not financed properly
• Factors underlying changes in exchange rates:

  • International competitiveness: increased competitiveness leads to currency appreciation
• Factors underlying changes in exchange rates:

  • Government intervention: governments may influence currency value, like China keeping the Yuan undervalued
• Effects of changing exchange rates on the domestic and external economy:

  • J-curve effect: devaluation initially increases import value, worsening the deficit, then export value decreases, reducing the trade deficit