Outline

1. Real versus nominal exchange rates

2. Exchange rate policy and welfare
3. The problem of over and undervaluation
4. From exchange rate policy to economic
growth
5. Exchange rate regimes
To float or not to float

Real versus nominal

exchange rates

eM P *
e=
P

Decrease in e
means real
appreciation
of domestic
currency

e = real exchange rate

eM = nominal exchange rate
P = price level at home
P* = price level abroad

Real versus nominal

exchange rates

eM P *
e=
P

Devaluation or increase
of eM makes e also rise
i.e. currency to
depreciate in real terms
unless P rises so as to
leave e unchanged

e= real exchange rate

eM = nominal exchange rate
P = price level at home
P* = price level abroad

Exchange rate policy and

welfare
Payments for imports of
Real exchange rate

goods, services, and

capital

Imports

Earnings from exports of

goods, services, and
capital

Exports
Foreign exchange

The problem of
overvaluation
Governments may try to keep the
national currency overvalued
To keep foreign exchange cheap
To have power to ration scarce foreign
exchange
To make GNP look larger in foreign
currency term than it is.
To keep prices of imported good low.

Stagnation and
overvaluation
Stagnation can result due to an
overvaluation of the national
currency
Remember: e = eMP*/P

Suppose e is kept low. This means p is

high. This will reduce export and
increase import, thereby adversely
affecting growth.

Problem of
undervaluation
National currency is kept at low level to
encourage export.
Again this can fuel inflation by reducing
domestic supply of goods.
This happens because more export
means more outflow and less import
means less inflow of goods.

How to correct
undervaluation
Under a floating exchange rate regime
Adjustment is automatic: e moves

Under a fixed exchange rate regime

Inflation will lower e
Does devaluation improve the current account?
The Marshall-Lerner condition

E X + EM > 1

The importance of
appropriate side measures
eM P *
e=
P
Remember:
It is crucial to exercise fiscal and monetary
restraint along with devaluation in order to
prevent prices from rising and thus eating
up the benefits of devaluation.
To work, nominal devaluation must result in
real devaluation.

J curve
Initial deterioration after devaluation and only
then improvement
Trade
Balance

Time

From exchange rate policy

to economic growth
How do we ensure that exchange rates do
not stray too far from equilibrium?
Either by floating
Then equilibrium follows by itself

or by strict monetary and fiscal discipline

under a fixed exchange rate
The real exchange rate always floats
Through nominal exchange rate adjustment or
price change, but this may take time

Why inflation is bad for

growth
We saw that inflation leads to
overvaluation which hurts exports
So, here is one reason why inflation
hurts economic growth
Exports and imports are good for
growth

Several other reasons

Inflation distorts production and impedes
financial development

How trade increases

efficiency and growth
Trade with other nations increases
efficiency by allowing
1. Specialization through comparative
advantage
2. Exploitation of economies of scale
3. Promotion of free competition

Trade takes place not only in goods

and services, but also in capital and
labour

How trade increases

efficiency and growth
Trade also encourages international
exchange of
Ideas
Information
Know-how
Technology

Trade imparts knowledge

Which is also good for growth!

Exchange rate regimes

There is a range of options
Monetary union or dollarization
Means giving up your national currency or sharing it
with others

Currency board
Legal commitment to exchange domestic for foreign
currency at a fixed rate

Fixed exchange rate (peg)

Crawling peg
Managed floating
Pure floating

Benefits and costs

Benefits

Costs

Fixed
exchange
rates

Stability of trade
and investment
Low inflation

Floating
exchange
rates

Efficiency
BOP equilibrium

Inefficiency
BOP deficits
Sacrifice of
monetary
independence
Instability of
trade and
investment
Inflation

Exchange rate regimes

In view of benefits and costs, no single
exchange rate regime is right for all
countries at all times
The regime of choice depends on time and
circumstance
If inefficiency and slow growth are the main
problem, floating rates can help
If high inflation is the main problem, fixed
exchange rates can help