Exchange Rates (Copy)

11.2.1 Measurement of Exchange Rates

• Nominal Exchange Rate:
  • The rate at which one currency can be exchanged for another.
  • Expressed as units of foreign currency per unit of domestic currency (or vice versa).
  • Example: 1 USD = 75 PKR.
• Real Exchange Rate:
  • Adjusted for price level differences between countries to reflect the relative purchasing power of currencies.
  • Formula:
    Real Exchange Rate = (Nominal Exchange Rate × Domestic Price Level) ÷ Foreign Price Level
  • Indicates competitiveness of a country’s goods internationally.
• Trade-Weighted Exchange Rate (Effective Exchange Rate):
  • Weighted average of a country’s currency relative to a basket of other currencies, weighted by trade volumes with those countries.
  • Better measure of overall external competitiveness than bilateral nominal rate.

11.2.2 Determination of Exchange Rates Under Fixed and Managed Systems

• Fixed Exchange Rate System:
  • Currency value is pegged to another currency or basket of currencies.
  • Central bank intervenes actively to maintain rate by buying/selling reserves.
• Managed (Dirty) Float System:
  • Exchange rates fluctuate with market forces but central bank intervenes occasionally to smooth volatility or guide value.
• Floating Exchange Rate System:
  • Determined purely by supply and demand in foreign exchange markets.
  • Central bank does not intervene.

11.2.3 Distinction Between Revaluation and Devaluation of a Fixed Exchange Rate

• Revaluation:
  • Official increase in the value of the domestic currency under a fixed regime.
  • Makes imports cheaper and exports more expensive.
• Devaluation:
  • Official decrease in the value of the domestic currency under a fixed regime.
  • Makes exports cheaper and imports more expensive.

11.2.4 Changes in the Exchange Rate Under Different Exchange Rate Systems

• Factors influencing supply and demand for currency: interest rates, inflation, trade flows, capital movements, speculation.

11.2.5 Effects of Changing Exchange Rates on the External Economy Using Marshall-Lerner and J Curve Analysis

• Marshall-Lerner Condition:
  • Devaluation (or depreciation) improves trade balance if the sum of price elasticities of demand for exports and imports is greater than 1.
  • If |Ex + Im| > 1 → Trade balance improves after depreciation.
  • If < 1 → Trade balance worsens.
• J Curve Effect:
  • After depreciation, trade balance initially worsens due to contracts, fixed quantities, and price effects.
  • Over time, quantities adjust, and trade balance improves, forming a J-shaped curve when plotted over time.

Diagrams

Diagram 1: Nominal vs Real Exchange Rate

Real Exchange Rate = (Nominal Rate × Domestic Price) / Foreign Price

Nominal Rate ↑ but if Domestic Inflation ↑ more → Real Exchange Rate ↓ (less competitive)

Diagram 2: Exchange Rate Systems

Diagram 3: Devaluation and Trade Balance (Marshall-Lerner)

Trade Balance
↑
|           Improvement if |Ex+Im| > 1
|        J-curve effect: initial worsening
|     /
|    /
|___/_________________________→ Time

Diagram 4: Effect of Devaluation on Exports and Imports

Price of Exports (Foreign Currency)
↑
| Devaluation → Price in Foreign Currency ↓
| Quantity demanded of exports ↑

Price of Imports (Domestic Currency)
↑
| Devaluation → Price in Domestic Currency ↑
| Quantity demanded of imports ↓

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Economics Full Scale Course