11.2 Exchange rates

Exchange-rate regimes describe how the currency value is determined: floating rates respond mainly to demand and supply; fixed rates are maintained near an official parity; managed regimes allow market movement with intervention.

The choice affects monetary autonomy, reserves, credibility and adjustment to shocks. A regime is not defined by one intervention: state the target, permitted band and response rule.

A central bank defending a fixed parity may buy its currency with foreign reserves when downward pressure appears; a floating central bank may instead change interest rates or tolerate the movement.

“Managed float” does not mean a permanently fixed price, and a stated peg is not credible if reserves or policy commitment cannot support it.

Under a fixed exchange-rate system the authorities maintain the currency near a chosen parity, while a managed system allows limited movement but intervenes when the rate approaches a target or band.

Defending the rate may require foreign reserves, interest-rate changes, capital controls or fiscal adjustment. Persistent pressure can force a devaluation, revaluation or abandonment of the regime.

If demand for a currency falls below the peg, the central bank can buy it with reserves. If reserves become scarce, the peg may be unsustainable without changing policy or the parity.

A fixed rate does not eliminate market pressure; it transfers adjustment to reserves, interest rates, output or the official 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 = $1.20 to$1.30, 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.

Moving from a fixed to a floating regime, or changing the width of a managed band, changes how the currency responds to shocks and how much the central bank must intervene.

A float preserves more monetary-policy autonomy but can create exchange-rate volatility. A peg can stabilise trade prices and expectations but requires reserves, credibility and adjustment through interest rates, prices or output.

A country abandoning a rigid peg may see a rapid depreciation that restores competitiveness but raises import prices; keeping the peg would instead require reserves or tighter domestic policy.

Changing the regime does not guarantee a particular exchange-rate direction or trade result; the initial imbalance and market expectations still matter.

The Marshall–Lerner condition says a depreciation improves the trade balance in the long run when the sum of the absolute export and import demand elasticities exceeds one, subject to the model’s assumptions.

The J-curve explains why the balance may worsen first: contracts, quantities and substitution adjust slowly while import prices rise immediately. The condition is about elasticities and the later response, not a guarantee for every economy.

If export-demand elasticity is 0.7 and import-demand elasticity is 0.6, their sum is 1.3, so the long-run condition is met in the simple model; the first months may still show a deficit.

The condition is not a short-run rule, and a depreciation does not improve the trade balance if contracts, supply capacity or pass-through invalidate the assumptions.