Exchange Rates (Copy)
11.2 Exchange Rates
11.2.1 Measurement of Exchange Rates
Nominal Exchange Rate
- Value of one currency in terms of another, without adjusting for price levels.
- Example: 1 USD = 280 PKR.
Real Exchange Rate
- Nominal exchange rate adjusted for relative price levels between countries.
- Formula: Real ER = Nominal ER × (Domestic Price Level ÷ Foreign Price Level).
- Reflects competitiveness more accurately than nominal rate.
Trade-Weighted Exchange Rate
- Weighted average of a country’s exchange rate against major trading partners’ currencies, weighted by trade shares.
- Shows overall currency strength in international trade context.
11.2.2 Determination of Exchange Rates Under Fixed and Managed Systems
| System | Determination Method | Role of Central Bank |
|---|---|---|
| Fixed | Pegged at set rate to another currency or basket. | Buys/sells currency to maintain peg. |
| Managed (Dirty Float) | Mostly market-determined but central bank intervenes occasionally. | Smooths excessive fluctuations. |
11.2.3 Revaluation vs Devaluation (Fixed Exchange Rate)
| Term | Definition | Effect |
|---|---|---|
| Revaluation | Official increase in currency’s fixed value. | Imports cheaper, exports less competitive. |
| Devaluation | Official decrease in currency’s fixed value. | Exports cheaper, imports more expensive. |
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
11.2.4 Changes in Exchange Rates Under Different Systems
- Floating: Determined by demand and supply in forex markets.
- Managed float: Market forces with occasional intervention.
- Fixed: Changes only via official revaluation/devaluation.
- Currency board: Fixed rate legally committed; changes rare and politically significant.
11.2.5 Effects of Changing Exchange Rates on the External Economy
Marshall–Lerner Condition
- Currency depreciation improves current account if:
PED for exports + PED for imports > 1.
J-Curve Analysis
- After depreciation:
- Short run: Current account may worsen (contracts fixed in foreign currency, inelastic demand).
- Long run: Improves as demand becomes more elastic and trade adjusts.
Summary Table – Depreciation/Appreciation Effects:
| Change | Exports | Imports | BOP Impact |
|---|---|---|---|
| Depreciation | ↑ competitiveness | ↓ demand due to higher prices | Improves if ML condition met |
| Appreciation | ↓ competitiveness | ↑ demand due to lower prices | Worsens if ML condition met |