Contents:

  1. Learning outcomes
  2. Definitions
  3. Measurement of Exchange Rates: Nominal vs Real
  4. Trade-Weighted Exchange Rates
  5. Determination of Exchange Rates Under Fixed and Managed System
  6. Change in Exchange Rate Under Different Exchange Rate Systems
  7. The Effects of Changing Exchange Rates on the External Economy

Candidates should be able to:

Definitions

Nominal exchange rate The rate at which one currency is converted into another. Sometimes, it is simply referred to as the foreign exchange rate
Real exchange rate A currency's worth in terms of what it can actually be used to purchase
Trade weighted exchange rate A weighted index that displays the proportional value of commerce between a nation and its trading partners
Purchasing power parity A method of displaying the exchange rate that compares the prices of a typical basket of items in two different countries
Fixed exchange rate Where a country's government decides the value of its exchange rate and is committed to maintaining that value
Pegged exchange rate The practice of controlling the rate at which one country's currency is exchanged for another, specific currency
Managed float Where a government steps in to control erratic currency movements on the foreign exchange market
Speculation When individuals purchase or sell a currency, based on their perception of how its value will change in the future
Dirty float Where a government purposefully keeps its exchange rate low to gain a trade advantage
Devaluation When a fixed exchange rate's value is decreased to a new, lower rate
Revaluation When a fixed exchange rate's value is increased to a new, higher rate
J curve The current account's immediate reaction to a sharp decline in the exchange rate.
Marshall-Lerner Argues that for a devaluation to result in an improvement in the current account, the total of the price elasticities of demand for exports and imports must be greater than one.

14.1 Measurement of Exchange Rates: Nominal vs Real

Nominal value, real value, and trade-weighted value are all ways to measure exchange rates. The exchange rate that is typically quoted is known as the nominal rate; for example, if you visit a bank or check the rate online, you will see this rate. What the currency is actually worth in terms of what it can be used to purchase is the true exchange rate. A common name for this is purchasing power parity.