Chapter 49
Exchange rates
LEARNING INTENTIONS
In this chapter you will learn how to:
• identify the three main ways exchange rates are measured:
nominal, real and trade-weighted exchange rates
• explain the difference between nominal and real exchange
rates
• explain trade-weighted exchange rates
• analyse how exchange rates are determined under fixed and
managed systems
• explain the difference between revaluation and devaluation of
a fixed exchange rate
• analyse the causes of changes in the exchange rate under
different exchange rate systems
• evaluate the effects of changing exchange rates on the
external economy using the Marshall–Lerner condition and J-
curve analysis.
ECONOMICS IN CONTEXT
Ghana’s changing current account balance
Ghana is a relatively open economy with low tariffs. The country
exports a high proportion of its output. Ghana imports an even
higher proportion of the products it consumes. The country’s main
exports include cocoa, horticultural products, gold and oil. Its
main imports include banking services, capital goods, cars and
rice. Figure 49.1 shows how Ghana’s exchange rate, inflation rate
and current account balance changed between 2012 and 2018.
Figure 49.1: Ghana: macroeconomic data, 2012–18
Two of Ghana’s main trading partners are China and India. Figure
49.2 compares Ghana’ s inflation rate with that of China and India.
Figure 49.2: The inflation rates of Ghana, China and India, 2013–
18
Discuss in a pair or a group:
• What happened to the internal and external value of the
Ghanaian currency over the period shown?
• In what ways do you think changes in the internal or external
value of the Ghanaian currency had more of an influence on
the country’s current account balance?
49.1 Measurement of exchange rates
There are a number of ways of measuring the price of a currency. It can,
for example, be measured in terms of how much it costs in another
currency. It can also be measured in terms of what can it buy in another
country or countries and in terms of a basket of currencies.
Nominal and real exchange rates
The nominal foreign exchange rate is the price of one currency in terms
of another currency. For example, 160 Pakistani rupees may buy one
US dollar.
Economists also measure real exchange rates. A real exchange rate
takes price changes as well as exchange rate changes into account to
assess changes in the competitiveness of a country’s products in global
markets. A fall in a country’s foreign exchange rate would be expected
to make its exports more price competitive. However, if the country is
experiencing a relatively high inflation rate, export prices may actually
be increasing. A real exchange rate compares the relative price of two
countries’ products:
nominal exchange rate × domestic price index
Real exchange rate =
foreign price index
The real exchange rate may rise as a result of an appreciation or an
increase in the country’s relative inflation rate. The price of products in
the country will increase relative to those in another country or
countries. More imports could be purchased for a given quantity of
exports. As the country’s products are more expensive relative to its
competitors, the country is likely to import more and export less. The
real exchange rate has more of an impact on the current account balance
than the nominal exchange rate as it reflects international price
competitiveness.
ACTIVITY 49.1
Suppose the US dollar:Mexican peso exchange rate is $1 = 20
pesos and that the US price index is 144 and the Mexican price
index is 120.
1 Calculate the real exchange rate.
2 Decide if the dollar is undervalued or overvalued.
3 Share your answer with another learner.
Trade-weighted exchange rate
In practice, a country trades with a number of other countries and it is
possible that its currency may rise in value against some countries while
falling against others. To gain an impression of the general change in a
country’s foreign exchange rate, economists measure trade-weighted
exchange rates. A trade-weighted exchange rate is a measure, in index
form, of the price of a currency against a basket of currencies. These are
weighted according to the relative importance of the countries in the
country’s trade. For example, if India undertakes three times as much
trade with China as it does with the US, the Chinese renminbi will be
given three times as much weight in the calculation as the US dollar.
TIP
Be careful in interpreting exchange rate changes. For example, if the
exchange rate between the Mexican peso and the US dollar changes
from 25 Mexican pesos to $1 to 28 Mexican pesos to $1, it means
that the Mexican peso is now worth less. To buy $1 now costs more
pesos.
49.2 Determination of exchange rates
Exchange rates can be determined by a government, by the free market
forces of demand and supply or by a combination of the two. Most
governments and their central banks today allow market forces to play a
large role in determining their countries’ exchange rates, but may
intervene if there are large fluctuations in their value.
A fixed exchange rate system
Figure 49.3: UAE dirhams
In a fixed exchange rate system, the price of the currency is determined
by the government. For instance, the value of the UAE’s dirham may be
fixed at 1 dirham = US$0.25. The UAE’s central bank will maintain the
rate by direct intervention and/or by trying to influence the market
demand for and supply of the currency. Direct intervention will involve
the central bank buying or selling the currency. It may try to influence
the market demand and supply by changing the rate of interest. If, for
instance, there is downward pressure on the exchange rate because the
supply of the currency is increasing on the foreign exchange market, the
central bank is likely to buy the currency. The central bank may also
increase the rate of interest. Such a measure may attract hot money
flows, with people buying the currency to place into accounts in the
country’s financial institutions. Figure 49.4 shows that the UAE
government fixes its exchange rate at 1 dirham = $0.25.
Figure 49.4: Central bank action to maintain the value of the UAE
dirham
If the supply of the currency increases to S1, the central bank may buy
enough of the currency to shift the demand curve to D1, and maintain
the value of the currency at $0.25.
It is easier for a central bank to maintain a fixed exchange rate if that
rate is set close to the long-run equilibrium value of the currency. This
is because it will only have to offset short-run – and possibly relatively
small – fluctuations. If, however, the exchange rate is overvalued, the
central bank may be in danger of running out of reserves trying to keep
the exchange rate at a level that does not reflect its market price.
One of the disadvantages of a fixed exchange rate is the need to keep
reserves. This involves an opportunity cost, as the foreign exchange or
gold, for instance, could be used for other purposes. There is also the
risk that a government may sacrifice other policy objectives in order to
maintain the fixed exchange rate. For instance, a central bank may raise
the interest rate in a bid to keep the exchange rate at the price the
government wants maintained. However, a higher interest rate may
reduce aggregate demand and increase unemployment.
Market pressures may mean that the rate at which the currency is fixed
may have to be changed over time. A reduction in the value of a fixed
exchange rate to a lower level is known as devaluation. A revaluation
occurs when the government raises the exchange rate to a new, higher
fixed rate.
A fixed exchange rate does create certainty, which can promote
international trade and investment. For instance, a foreign firm may be
more willing to set up a branch in the country if it knows how much any
revenue it earns will be worth in its own currency.
A fixed exchange rate also imposes discipline on a government to keep
inflation low, so that a loss of international price competitiveness does
not put downward pressure on the exchange rate.
A managed system
A managed system, in effect, combines features of a floating exchange
rate system and a fixed exchange rate system. It usually involves a
government allowing the exchange rate to be determined by market
forces within a given band, which has upper and lower limits. Figure
49.5 shows that the government sets a central value of P, an upper band
of Pa, which it does not want the exchange rate to exceed, and a lower
limit of Pb, which it does not want it to fall below.
Figure 49.5: A managed system
If the exchange rate is within the limits, for example at Pc, no action
will be taken. If, however, demand for the currency were to rise to D1,
the central bank would sell the domestic currency to increase supply to
S1 and so keep the exchange rate within the desired band.
KEY CONCEPT LINK
Equilibrium and disequilibrium: A fixed exchange rate is easier
to maintain if it is set close to its long-run equilibrium price.
ACTIVITY 49.2
Switzerland’s main trading partners are member countries of the
European Union. In 2011, demand for the Swiss franc increased by
a significant amount. The Swiss National Bank, (SNB) the
country’s central bank, wanted to keep the exchange rate to €1 =
1.2 Swiss francs. The SNB initially lowered the interest rate to
near zero and then bought large quantities of euros. The Swiss
exchange rate also came under upward pressure in 2015 when the
SNB took similar action. Figure 49.6 shows the euro–Swiss franc
exchange rate between 2011 and 2019.
Explain:
1 What is an advantage of a stable exchange rate?
2 Why might a central bank want to avoid a rise in its country’s
exchange rate?
3 What would have happened to the price of Swiss exports
between 2017 and 2018?
Compare your answers with another learner.
Figure 49.6: The euro-Swiss franc exchange rate, 2011–19
49.3 Revaluation and devaluation of a fixed
exchange rate
A revaluation occurs when a government raises the exchange rate to a
new, higher fixed rate. This higher price will be maintained by the
government. If there is downward pressure on the currency, the central
bank will buy the currency, using some of its reserves. It might also
raise the interest rate.
A devaluation is a reduction in the price of the currency arising from a
government’s decision to maintain it at a new lower level. If there is
upward pressure on the new, lower exchange rate, the central bank will
sell its currency. The increased supply of the currency on the foreign
exchange market may keep the price low. The central bank might also
lower the interest rate to reduce demand for the currency and increase
its supply.
Devaluations and revaluations occur for two main reasons. One reason
is that the current exchange rate is not sustainable. It results in surpluses
or shortages of the currency in the foreign exchange market. The second
reason is the use of devaluations and revaluations as a policy tool.
KEY CONCEPT LINK
The role of government and issues of equality and equity: A
devaluation is likely to benefit firms that export but may harm
firms that import raw materials and capital goods and consumers
who may now have to pay higher prices.
TIP
Remember to use the terms appreciation and depreciation in
connection with a floating exchange rate, and revaluation and
devaluation in connection with a fixed exchange rate.
ACTIVITY 49.3
Figure 49.7: The Caribbean Island of Aruba
1 The Aruban government decides to revalue its currency, the
Aruban florin, from 1 florin = $0.56 to 1 florin = $0.65. In a
pair, decide which groups would gain and which groups
would lose as a result of this decision:
a Aruban consumers
b Aruban importers
c Exchange rate dealers
d US consumers
e US exporters
f US tourists to Aruba
49.4 Changes in the exchange rate under
different exchange rate systems
Section 28.4 discussed how a floating exchange rate will change when
there are changes in the market forces of demand and supply. The main
reasons why demand for the currency may rise are increases in demand
for the country’s goods and services, increases in direct and portfolio
investment in the country and speculation that the currency will rise in
price. The supply of the currency will decrease if the country buys
fewer imports, invests less abroad and it is expected that the currency
will rise in price.
A fixed exchange rate does not often change. A change when it does
occur is the result of a government decision. As mentioned above, a
government will devalue its currency if the government thinks that it
cannot maintain its current price. If market forces are putting downward
pressure on the price of the currency, there is a risk that the central bank
will run out of the reserves that it can use to buy the currency. A
government may also be reluctant for its central bank to raise the
interest rate to encourage hot money flows. This is because the higher
interest rate could reduce economic activity. A government may also
devalue the currency to increase the international competitiveness of its
products so as to reduce a current account deficit, increase economic
growth and reduce unemployment.
A government may instruct its central bank to bring about a revaluation
of the currency if it thinks there is too much upward pressure on the
currency. The government may not want to sell large quantities of its
currency to keep the exchange rate down to its target rate as this action
may add to the money supply. A government may also revalue its
currency to reduce inflationary pressure. A higher exchange rate will
reduce the price of imports, which can increase the pressure on
domestic industries to become more internationally competitive.
TIP
Remember in answering essay questions that changes in the
exchange rate alter export prices in terms of foreign currency
whereas they alter import prices in terms of the domestic currency.
THINK LIKE AN ECONOMIST
Uzbekistan’s exchange rate
Figure 49.8: Tashkent, the capital of Uzbekistan
In August 2019, the government of Uzbekistan decided to move
from operating a managed exchange rate to a floating exchange
rate. Before this date, the government had instructed its central
bank to limit movements in the exchange rate of its currency, the
somoni, with the US dollar to 5%. The government said it was
making the change in its exchange rate system to increase
economic growth and living standards. Just before the
announcement, the exchange rate had come under downward
pressure from an increase in imports.
1 Predict what you would expect to have happened to the price
of the somoni in 2020.
2 Research what happened to the somoni’s price last year.
49.5 The effects of changing exchange rates
on the external economy
The effect of a change in the exchange rate on the current account
balance will be influenced by the price elasticities of demand for
exports and imports (see Section 28.1). The requirement for the
combined elasticities to exceed 1 for the trade balance, and so the
current account balance, to be improved by a change in the exchange
rate is known as the Marshall–Lerner condition. If this condition is
met, a fall in the exchange rate would reduce a current account deficit,
while a rise in the exchange rate would reduce a current account
surplus. The table below uses simplified figures to illustrate the
Marshall–Lerner condition in the case of a fall in the exchange rate.
The greater the combined PED for exports and imports, the smaller will
be the fall in the exchange rate required to improve the current account
position. If the PED is less than 1, a revaluation of the exchange rate
would be the more appropriate policy strategy.
Initially £1 (UK currency) = $1.5
• 40 products, which would sell at £10 each in the home
market, sell for $15 in the US. Export revenue = £400 ($600)
• 50 imports from the US, which sell in the US at $30, are
purchased in the UK at £20 each. Import expenditure = £1000
($1500)
• Deficit = £400 − £1000 = £600
Then the pound sterling falls in value to £1 = $1.
• PED for exports = 0. Price in US falls to $10 each. Total
export revenue is now 40 × $10 = $400 which is now
converted into £400, leaving export revenue in pounds
sterling unchanged.
• PED for imports = −1.2. Price of the $30 product will rise to
£30, a 50% increase. Demand falls by 60% to 20. Total
import expenditure now equals £600.
• The deficit is now £400 − £600 = £200. It has fallen by £400.
The J curve effect is related to the Marshall–Lerner condition. In some
cases, a fall in the exchange rate will actually worsen the current
account position before it starts to improve it. This is because, in the
short run, demand for imports and exports may be relatively inelastic. It
takes time to recognise that prices have changed and then to search for
alternative products. In the long run, demand becomes more elastic and
the current account position may move from deficit into surplus as
shown in Figure 49.9.
Figure 49.9: The J curve effect
A higher exchange rate may increase a current account deficit or reduce
a current account surplus, but the outcome will depend mainly on the
price elasticities of demand for exports and imports. The Marshall–
Lerner condition and the J curve work in reverse. So, a current account
surplus will only be reduced if the sum of the price elasticities of
demand for exports and imports is greater than 1. A rise in the exchange
rate may increase a current account surplus in the short run before
reducing it in the longer run as shown in Figure 49.10
Figure 49.10: The reverse J curve effect
TIP
In explaining the J curve effect, it is useful to draw the diagram.
KEY CONCEPT LINK
Time: Differences in the short run and longer run response to a
change in the exchange rate are the reason for the J curve effect.
ACTIVITY 49.4
In a pair, prepare a leaflet for AS Level Economics learners who
are studying exchange rates on whether your country’s central
bank should seek to increase or reduce the value of your country’s
currency, or leave it unchanged.
REFLECTION
How did preparing the leaflet help you understand the influences
on the decisions central banks make about their countries’
exchange rates?