11.4 - Exchange Rates
Ways of measuring currency prices
Currency prices can be assessed in several ways, each providing different insights into a currency's value and its role in international trade.
Key methods of measuring currency prices:
- Against another currency - This compares the value of one currency directly to a single other currency.
- Purchasing power in other countries - This considers what a currency can actually buy abroad.
- Against a basket of currencies - This involves comparing a currency to a group of others.
Nominal and real exchange rates
Exchange rates can be expressed in nominal or real terms, with each type serving distinct purposes in analysing international competitiveness.
Nominal exchange rates
The nominal exchange rate is the straightforward price of one currency expressed in terms of another. For instance, it might take 250 Indian rupees to purchase one British pound, indicating the direct conversion rate between the two.
Real exchange rates
The real exchange rate adjusts the nominal rate for differences in price levels between countries, offering a better view of how competitive a nation's products are internationally.
Where:
- Nominal exchange rate = The basic rate of exchange between two currencies
- Domestic price index = A measure of average prices in the home country
- Foreign price index = A measure of average prices in the foreign country
Impacts of changes in real exchange rates:
- Rise in real exchange rate - This can occur due to currency appreciation or higher inflation at home compared to abroad, making domestic products more expensive relative to foreign ones. As a result, exports may decrease while imports increase.
- Influence on current account balance - Changes in the real exchange rate have a stronger effect on a country's balance of trade than nominal rates alone, as they directly reflect relative price competitiveness in global markets.
Worked example - Calculating real exchange rate
Suppose the nominal exchange rate between the British pound and the euro is £1 = €1.25. The domestic price index in the UK is 120, and the foreign price index in the eurozone is 115. Calculate the real exchange rate.
Step 1: Identify the values
- Nominal exchange rate = 1.25
- Domestic price index = 120
- Foreign price index = 115
Step 2: Apply the real exchange rate formula
Step 3: Calculate the real exchange rate
Step 4: Interpretation
A real exchange rate of 1.304 indicates that UK goods are slightly more expensive relative to eurozone goods after adjusting for price levels, which could reduce UK export competitiveness.
Trade-weighted exchange rates
A trade-weighted exchange rate is an index that tracks a currency's price against a basket of other currencies, with each weighted based on the volume of trade with that country. For example, if the UK trades three times as much with Germany as with Japan, the euro would carry three times the weight of the Japanese yen in the index.
Methods of determining exchange rates
Exchange rates can be set through different systems, ranging from full government control to reliance on market dynamics, or a mix of both.
Main methods of exchange rate determination:
- Fixed by government - The rate is set and maintained by official intervention.
- Free market forces - Rates fluctuate based on supply and demand without interference (floating system).
- Combination approach - Market forces play a role, but with some government oversight (managed system).
Fixed and managed exchange rate systems
Fixed and managed systems involve government involvement to stabilise currency values, each with specific mechanisms, advantages, and drawbacks.
Fixed exchange rate systems
In a fixed exchange rate system, the government sets the currency's value and uses the central bank to keep it stable through interventions.
Central bank interventions in fixed systems:
- Direct actions - Buying the domestic currency with foreign reserves to support it during downward pressure, or selling it to counteract upward pressure.
- Interest rate adjustments - Increasing rates to draw in foreign capital and strengthen the currency, or decreasing them to ease demand and weaken it.
Fixed rates are simpler to sustain when aligned with the currency's natural long-term equilibrium value.
Advantages and disadvantages of fixed exchange rates:
| Aspect | Advantages | Disadvantages |
|---|---|---|
| Economic certainty | Provides stability for international trade and investment decisions | Requires holding large foreign reserves, creating opportunity costs |
| Policy discipline | Encourages governments to control inflation to maintain the fixed rate | May force sacrifices in other economic goals |
| Overall impact | Reduces uncertainty in global transactions | Can lead to imbalances if the rate is unsustainable |
Changes in fixed exchange rates:
- Devaluation - Lowering the fixed rate to a new, reduced level.
- Revaluation - Increasing the fixed rate to a higher level.
Reasons for these changes include correcting unsustainable rates that cause market distortions or using them deliberately to influence economic outcomes.
Managed exchange rate systems
In a managed exchange rate system, market supply and demand primarily set the rate, but within a predefined band with upper and lower boundaries. The central bank steps in only when the rate nears these limits, using similar tools as in fixed systems.