11.2 Exchange rates
- Syllabus
- 9708–2026–2027
- Topic
- 11.2
- Level
- A2
Learning objectives
11.2.1Exchange rate measures• Measurement of exchange rates:- distinction between nominal and real exchange rates- trade-weighted exchange rates11.2.2Fixed/managed exchange rates• Determination of exchange rates under fixed and managed systems11.2.3Revaluation vs devaluation• Distinction between revaluation and devaluation of a fixed exchange rate11.2.4Exchange rate system changes• Changes in the exchange rate under different exchange rate systems11.2.5Marshall-Lerner and J-curve• The effects of changing exchange rates on the external economy using Marshall-Lerner and J curve analysis
Nominal, real and trade-weighted rates measure different exchange values
| Measure | What it measures | Main use |
|---|---|---|
| Nominal bilateral exchange rate | Price of one currency in another at the stated date | Convert currencies and track market/official appreciation or depreciation |
| Real exchange rate | Nominal rate adjusted for relative domestic/foreign price levels | Compare price competitiveness after inflation differences |
| Trade-weighted exchange-rate index | Index of bilateral currency values weighted by each partner's share of the country's trade | Summarise currency movement against the important trading-partner basket |
Always state the quotation. If E is domestic currency per unit of foreign currency, a rise in E is a nominal depreciation and a common real-rate convention is RER = E x P_foreign / P_domestic; a rise is a real depreciation. If the quotation is reversed, the interpretation/formula direction reverses too.
ΔTWI ≈ Σ(w_i × Δe_i)
Base index 100: 80% of trade is with partner A and the currency rises 10% against A; 20% is with B and it rises 50%. Weighted change = 0.80 x 10% + 0.20 x 50% = 18%, so the new simplified index is 118.
Trade weights are partners' relative shares of total trade, not trade as a share of GDP or the terms of trade. A nominal appreciation can coexist with a real depreciation under a reversed quotation/large inflation differential, so define the convention before concluding competitiveness.
Fixed and managed rates require intervention against market pressure
| System | Determination rule | Intervention commitment |
|---|---|---|
| Fixed/peg | Official parity or very narrow band | Authorities defend the target continuously/when threatened |
| Managed float | Market determines most movements within an unstated/stated range | Authorities intervene selectively to limit volatility or steer the rate |
| Market pressure | Direct intervention | Supporting action and cost |
|---|---|---|
| Excess supply/downward pressure on domestic currency | Central bank buys domestic currency and sells foreign reserves | Raise interest rates, tighten fiscal policy or restrict capital outflow/import demand; reserves fall and domestic objectives may suffer |
| Excess demand/upward pressure | Central bank sells domestic currency and buys foreign currency | Lower rates/expand demand or relax controls; reserves rise and inflation risk may increase |
If a fixed rate is set above the market equilibrium under a domestic-currency-per-foreign quotation convention, translate carefully; in any diagram identify whether the official price creates excess demand or supply for the named currency, then make the authority absorb that gap. Never choose buy/sell action from 'above' alone without reading axes.
A peg gives predictable trade prices and possible anti-inflation credibility, but consumes reserves and monetary autonomy. A managed float needs less continuous defence and absorbs some shocks through the rate, but offers less certainty and still requires reserves/credibility.
A fixed rate does not eliminate demand/supply pressure; it transfers adjustment to reserves, rates, controls, output or a later parity change. Persistent current-account deficits or capital flight can exhaust reserves and force devaluation/exit.
Revaluation and devaluation are official changes to a fixed-rate parity
A revaluation is an official increase in the value of a currency under a fixed or managed regime; a devaluation is an official decrease. They differ from appreciation and depreciation, which usually describe market movements.
Revaluation makes imports cheaper and exports less competitive; devaluation tends to reverse those effects, subject to elasticities, imported inputs, debt currency and policy credibility.
If a government changes a peg from 1 unit = 1.20to1.30, the currency has been revalued under that quotation; changing it to $1.10 is a devaluation.
Do not use appreciation/depreciation for an announced parity change without noting the regime, and do not assume devaluation automatically improves the trade balance.
Changing exchange-rate systems reallocates adjustment pressure
| Feature | Fixed | Managed float | Free float |
|---|---|---|---|
| Rate adjustment | Official parity changes rarely | Market movement plus selective intervention | Continuous market movement |
| Reserves/defence | High potential requirement | Moderate/variable | No routine target defence |
| Monetary autonomy | Constrained by parity | Partial | Greater, subject to inflation/financial goals |
| Stability/credibility | More predictable if credible | Middle ground | Potential volatility/overshooting |
| Shock absorption | Reserves, rates, wages/prices and output | Shared between rate and policy | Exchange rate adjusts most directly |
When an overvalued fixed rate with a persistent deficit is released to float, excess currency supply may cause depreciation: competitiveness may improve, while imports and foreign-currency debt become dearer. If the prior parity was undervalued/surplus pressure dominates, the float may appreciate instead.
Under a fixed rate, higher domestic inflation than partners weakens export competitiveness and raises imports, creating pressure to devalue. Maintaining the parity instead may require reserve loss and contractionary policy, shifting the burden to output and unemployment.
Evaluate regime change by reserve adequacy, inflation credibility, trade exposure, capital mobility, financial balance sheets, shock type and institutional commitment. Certainty benefits traders; autonomy helps respond to domestic shocks.
A float is not guaranteed stable or instantly self-correcting, and a peg does not permanently remove a deficit. A regime change determines the adjustment process, not a guaranteed exchange-rate or trade outcome.
Marshall-Lerner predicts the long run; the J-curve explains the delayed path
|PED_X| + |PED_M| > 1
In the simplified Marshall-Lerner model, a depreciation/devaluation improves the trade/current-account balance in the long run when the absolute price elasticities of demand for exports and imports sum to more than one. Neither elasticity must individually exceed one.
If |PED_X| = 0.7 and |PED_M| = 0.6, the sum is 1.3, so the condition is met. Export quantities rise and import quantities fall enough, in value terms under the model assumptions, to outweigh the immediate price change.
| Period after depreciation | Price/quantity response | Likely current-account path |
|---|---|---|
| Immediate/short run | Import prices in domestic currency rise; contracts, habits and quantities adjust slowly, so demand is inelastic | Import bill may rise and balance worsen: downward part of J |
| Adjustment | Buyers substitute, export orders/production respond and elasticities increase | Deterioration bottoms out |
| Long run | If Marshall-Lerner holds and supply can expand | Export receipts/import saving improve balance above its starting path |
For appreciation/revaluation, reverse the long-run direction: when the condition holds, exports weaken and imports rise, tending to worsen a deficit or reduce a surplus. With low short-run elasticities, the current-account value may initially move in the opposite direction before quantities adjust.
The elasticity sum is not sufficient for every macro objective. Also test export supply capacity/PES, spare capacity, imported-input share and inflation, relative foreign income/inflation, retaliation/protection, competitor currencies, pass-through, foreign debt and time. Meeting Marshall-Lerner does not guarantee immediate improvement or low inflation.