Exchange rates

Economics A2 · International economic issues. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

The nominal exchange rate is the price of one currency in terms of another. The real exchange rate adjusts it for differences in price levels, so it shows competitiveness. A trade-weighted exchange rate is an index of a currency's value against a basket of currencies, each weighted by its share of the country's trade.

Under a floating system, demand and supply set the rate, and it appreciates or depreciates. Under a fixed system the central bank holds the rate by buying or selling its currency with reserves, or by changing interest rates; an official change is a devaluation or revaluation. A managed float is market-determined, with intervention when the central bank chooses.

Rules to remember

Real exchange rate = nominal exchange rate × (domestic price level ÷ foreign price level).
Trade-weighted index = sum of (each partner's trade weight × the exchange rate index against that partner).
Fixed rate with excess supply of the currency: the central bank buys its own currency with foreign reserves or raises interest rates.
Devaluation: an official lowering of a fixed rate. Depreciation: a fall in a floating rate caused by market forces. Revaluation and appreciation are the opposites.
A floating currency appreciates when demand for it rises (more exports, higher interest rates, inward investment) or its supply falls.
Marshall-Lerner condition: a depreciation improves the balance of trade only if PED for exports + PED for imports is greater than 1 (ignoring the minus signs).
J curve: after a depreciation the trade balance first worsens, because demand is inelastic in the short run, and later improves as buyers adjust.

Common mistake

Students test each elasticity separately against 1. The Marshall-Lerner condition uses the sum of the two elasticities, so 0.6 and 0.7 satisfy it even though each is inelastic.

Worked example

The price elasticity of demand for a country's exports is −0.9 and for its imports is −0.5. Its currency depreciates. What happens to its balance of trade?

Ignore the minus signs and add: 0.9 + 0.5 = 1.4.
1.4 is greater than 1, so the Marshall-Lerner condition is met.
Export earnings rise and import spending changes by enough for the trade balance to improve, once quantities have had time to adjust (J curve).

Answer: The balance of trade improves in the long run, possibly after worsening at first.

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