Economics (9708) | Exchange rates

🌍 International Economic Issues: Exchange Rates (Syllabus 6.4 & 11.2)

Hello future Economist! This chapter is incredibly important because exchange rates are the "price tags" that allow international trade to happen. They connect a country’s money to the rest of the world.
Understanding how currency prices are set and changed will help you analyze macroeconomic policy, trade flows, inflation, and economic stability. Don't worry if the vocabulary seems confusing—we will break down the floating systems (demand and supply) and the fixed systems (government control) step by step!

1. Defining the Exchange Rate (AS Level Core)

The Exchange Rate is simply the price of one currency expressed in terms of another currency.

How to Express an Exchange Rate

When you see an exchange rate, it tells you how much of one currency you need to buy one unit of the other.

• Example: If the exchange rate is $1 = €0.90, it means 1 US dollar can buy 0.90 Euros.
• Example: If the exchange rate is £1 = ¥180, it means 1 British Pound can buy 180 Japanese Yen.

Appreciation vs. Depreciation (Floating System)

These terms describe changes in a currency’s value when it is determined by market forces (supply and demand).

• Appreciation: The value of a currency rises relative to another currency. You need fewer units of the home currency to buy one unit of the foreign currency.
  Example: If $1 used to buy €0.90, and now $1 buys €1.10, the Dollar has appreciated (gotten stronger).
• Depreciation: The value of a currency falls relative to another currency. You need more units of the home currency to buy one unit of the foreign currency.
  Example: If $1 used to buy €0.90, and now $1 buys €0.70, the Dollar has depreciated (gotten weaker).

2. Determination of a Floating Exchange Rate (AS Level Core)

A Floating Exchange Rate system means the value of the currency is determined purely by the market forces of demand and supply on the foreign exchange market, with no (or very limited) government intervention.

The Market for the Home Currency (e.g., The Dollar)

A. Demand for the Currency

Who wants to buy the domestic currency (the Dollar)? Foreigners do, because they need Dollars to pay for US goods, services, or investments.

Factors that cause the Demand Curve to shift right (leading to appreciation):

1. Increase in Domestic Exports (X): If US goods become more popular internationally, foreigners need more Dollars to buy them.
2. Higher Domestic Interest Rates: If US interest rates are higher than abroad, foreign investors buy US assets (like bonds) to get better returns, thus demanding Dollars (called "hot money" flow).
3. Improvement in Domestic Investment Climate: If the US economy looks stable and profitable, Foreign Direct Investment (FDI) inflows increase, demanding Dollars.
4. Speculation: If traders believe the currency will appreciate in the future, they buy it now.

B. Supply of the Currency

Who offers the domestic currency (the Dollar) for sale? Domestic residents who want to buy foreign currency to pay for foreign goods, services, or investments abroad.

Factors that cause the Supply Curve to shift right (leading to depreciation):

1. Increase in Domestic Imports (M): If US residents buy more foreign goods, they sell their Dollars to buy foreign currency (like Euros or Yen).
2. Lower Domestic Interest Rates: If interest rates fall domestically, investors pull their money out of the country to seek higher returns elsewhere, increasing the supply of the Dollar on the market.
3. Domestic residents invest abroad: Increased outflow of capital increases the supply of the Dollar.

Step-by-Step Analysis using Demand and Supply

Let's analyze what happens if US exports become very popular (increased demand for the Dollar):

1. Foreign demand for US goods rises (e.g., demand for American software).
2. Foreigners need more US Dollars to pay for the software. This shifts the Demand curve for the Dollar to the right (D to D1).
3. The equilibrium exchange rate rises (e.g., from $1 = €0.90 to $1 = €1.10).
4. The Dollar appreciates against the Euro.

3. Exchange Rates and Macroeconomic Performance (AS Level Core)

Changes in the exchange rate have a powerful impact on a country's main macroeconomic objectives: inflation, growth, and the balance of payments. We use the AD/AS model to analyze this impact (Syllabus 6.4.5).

Impact of Currency Depreciation (A Weaker Currency)

A depreciation makes domestic goods cheaper for foreigners and foreign goods more expensive for domestic buyers.

1. Exports (X) increase and Imports (M) decrease (assuming trade demand is elastic).
2. Net Exports (\(X-M\)) rise.
3. Aggregate Demand (AD) shifts right: \(AD = C + I + G + (X - M)\) increases.
4. Economic Growth and Employment: Higher AD leads to an increase in real output and a fall in unemployment.
5. Inflation (Price Level): Higher AD causes demand-pull inflation. Additionally, imports are more expensive, leading to imported cost-push inflation (e.g., imported oil costs more).

Think of the UK holidaymaker: When the Pound depreciates, their foreign holiday is much more expensive (making imports—foreign services—dearer).

Impact of Currency Appreciation (A Stronger Currency)

An appreciation makes domestic goods more expensive for foreigners and foreign goods cheaper for domestic buyers.

1. Exports (X) decrease and Imports (M) increase.
2. Net Exports (\(X-M\)) fall.
3. Aggregate Demand (AD) shifts left.
4. Economic Growth and Employment: Lower AD leads to slower growth and potentially higher unemployment.
5. Inflation (Price Level): Lower AD reduces demand-pull inflation. Crucially, imports are now cheaper, lowering domestic costs and contributing to disinflation (a fall in the inflation rate).

4. Fixed and Managed Exchange Rate Systems (A Level Extension)

While many major currencies float, some countries, especially developing ones, prefer to fix or manage their rates to promote stability for trade.

Fixed Exchange Rate Systems (Pegged)

A Fixed Exchange Rate system is one where the government (via the Central Bank) commits to keeping the value of its currency constant against another major currency (like the US Dollar) or a commodity (like gold).

• Maintaining the Peg: If market demand falls below the fixed rate, the Central Bank must use its foreign reserves (e.g., Dollars, Gold) to buy up its own currency to maintain the target price. If demand rises too high, the bank sells its own currency.
• Revaluation: When a government decides to officially raise the fixed exchange rate (make the currency stronger).
• Devaluation: When a government decides to officially lower the fixed exchange rate (make the currency weaker).

Managed Exchange Rate Systems (Dirty Float)

A Managed Float system is a hybrid approach. The currency is allowed to float freely, but the Central Bank intervenes occasionally to prevent extreme fluctuations or steer the rate toward a desired band.

Trade-offs between Fixed and Floating Systems

| Feature | Floating Rate | Fixed Rate | | :--- | :--- | :--- | | Stability | Low (High volatility) | High (Certainty for trade/investment) | | Autonomy | High (Monetary policy can be used for domestic goals) | Low (Monetary policy must be used to maintain the rate) | | Adjustment | Automatic (No need for policy action) | Requires intervention (Loss of reserves) | | Policy Terminology | Appreciation/Depreciation | Revaluation/Devaluation |

5. Measuring Exchange Rates (A Level Extension)

Nominal vs. Real Exchange Rates

The Nominal Exchange Rate is the rate we use every day—the price of one currency in terms of another (e.g., $1 = €0.90).

The Real Exchange Rate (RER) adjusts the nominal rate for the relative price levels (inflation) between the two countries. The RER tells you how competitive a country's goods are, after accounting for inflation.

$$RER = Nominal Exchange Rate \times \frac{Domestic\ Price\ Level}{Foreign\ Price\ Level}$$

Importance: If Country A's currency appreciates nominally by 10%, but its domestic inflation is 20% higher than Country B, its RER may still show that Country A’s goods are less competitive overall.

Trade-Weighted Exchange Rate Index (TWI)

Since a country trades with many partners, using just one bilateral rate (e.g., the rate against the USD) can be misleading. The Trade-Weighted Exchange Rate (or Effective Exchange Rate) measures the value of a currency against a weighted average of the currencies of its major trading partners.

The weights used are based on how much trade (imports and exports) is done with each partner. This gives a much more accurate picture of a country's overall international competitiveness.

6. Advanced Analysis: Marshall-Lerner and the J-Curve (A Level Advanced)

When a country depreciates or devalues its currency to improve its Current Account Balance (CAB), the policy’s success is not guaranteed immediately.

The Marshall-Lerner Condition (MLC)

The MLC states the condition under which a depreciation (or devaluation) will actually improve the trade balance (Net Exports, \(X-M\)).

The MLC says that the CAB will improve only if the sum of the Price Elasticity of Demand for exports (PEDx) and the Price Elasticity of Demand for imports (PEDm) is greater than one (in absolute terms).

$$\mathbf{PED_x + PED_m > 1}$$

Why this condition? A depreciation causes two conflicting effects:

1. Price Effect (Negative): Exports earn less foreign currency and imports cost more domestic currency. This initially worsens the trade balance.
2. Quantity Effect (Positive): Since exports are cheaper and imports are dearer, the volume (quantity) of exports increases and the volume of imports decreases. This improves the trade balance.

For the policy to work, the positive Quantity Effect must be strong enough to outweigh the negative Price Effect. This happens only when demand is sufficiently price elastic (i.e., MLC > 1).

The J-Curve Effect

The J-Curve describes the typical time lag pattern seen when a currency depreciates (or is devalued).

Step 1: Immediate Term (The Vertical Drop)

• The trade balance worsens immediately after depreciation.
• This is because most export/import contracts are already signed, so the volumes (quantities) don't change yet.
• Demand is highly inelastic in the short run (MLC < 1). The negative price effect dominates.

Step 2: Medium/Long Term (The Curve Upwards)

• Over time, consumers and firms respond to the new prices. Exporters find new markets, and domestic consumers switch from expensive imports to cheaper domestic goods.
• Demand becomes more elastic (MLC > 1). The positive quantity effect dominates.
• The trade balance eventually improves, following the shape of the letter 'J'.