Exchange Rates and Open

Economy Macroeconomics
Macroeconomics
Lecture 19
https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1340 A lighthearted take on Monetary Policy
Recap…

• International trade, movement of labour and capital, and exchange rates affect an
economy
• Net exports affect GDP. When NX>0, it adds to the aggregate demand
• Countries trade with each other for various reasons
• As a way to manage surplus and shortages
• As a way of improving efficiency (specialization)
• Due to tastes and preferences
• As a participant of global value chains
• Due to economies of scale
 ACt
ACs DdT
Dds
Country A

QT
Qs
ACt
DdT
ACs Dds

Country B

Qs QT

Identical countries, two industries, each with economies of

scale, possible to gainfully engage in trade
 ACt
ACs DdT
Dds
Country A

QT
Qs
ACt
DdT
ACs Dds

Country B

Qs QT

No Trade. Both countries produce both the goods

ACs
Dds Dds Total demand for shirts coming from both the countries

Country A

Qs
ACt
DdT Total demand for trousers coming from both the countries

Country B

QT

Trade. Each country specialize in one good and service the demand for both the countries
The Choice between Domestic
Goods and Foreign Goods
• When goods markets are open, domestic consumers must
decide not only how much to consume and save, but also
whether to buy domestic goods or to buy foreign goods.

• Central to the second decision is the price of domestic

goods relative to foreign goods, or the exchange rate.

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 • An exchange rate can be defined as a price
of one country’s money in terms of
another country.

What is an • Each country measures the price of its

exchange goods and services using a particular scale
of measurement.
rate?
• The exchange rate provides a conversion
tool which allows expressing prices of one
country in terms of the units of
measurement of the other country.
Nominal Exchange Rates
• Nominal exchange rates between two currencies can be
quoted in one of two ways:

• As the price of the domestic currency in terms of the

foreign currency.

• As the price of the foreign currency in terms of the

domestic currency.

• Note that both the conventions are used in textbooks. In

India, we generally express it as INR/$ terms

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Nominal Exchange Rates:
Appreciation and Depreciation
• The nominal exchange rate is the price of the foreign
currency in terms of the domestic currency.

• An appreciation of the domestic currency is an increase in

the price of the domestic currency in terms of the foreign
currency, which corresponds
to a increase in the exchange rate.

• A depreciation of the domestic currency is a decrease in

the price of the domestic currency in terms of the foreign
currency, or a decrease in the exchange rate.

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Nominal Exchange Rates:
Revaluations and Devaluations

When countries operate under fixed exchange

rates, that is, maintain a constant exchange rate
between them, two other terms used are:
Revaluations, rather than appreciations, which
are decreases in the exchange rate, and

Devaluations, rather than depreciations, which

are increases in the exchange rate.

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 • Under the gold standard system, countries fixed the value of their
currencies in terms of a specific amount of gold.
A very brief
• The government or the central bank ensured complete two-way
history of convertibility between money and gold. That means that the
central bank would freely exchange money to gold at the specified
exchange rate and vice versa.

rates • To ensure this convertibility, the amount of money issued by the

central bank was tied to the amount of gold in its reserve.

• Given that each currency was tied to a specific amount of gold,

bilateral exchange rates were automatically fixed.

Introduction of
• For example, if Britain fixes the value of pound to £10 per ounce of
Gold Standard gold and USA fixes the value of dollar to $20 per ounce of gold,
(1870–1914) them the bilateral dollar to pound exchange rate is fixed as $2/£.
 • The 35-year-old Gold Standard was suspended, and countries floated
their currency

• US maintained gold convertibility of US dollar but since other

countries floated their exchange rates, dollar had a floating value
against other currencies.

The Interwar • International Economic Disintegration

Period • Many countries suffered during the Great Depression.
• Major economic harm was done by restrictions on international
(1918-1939) trade and payments.
• Beggar thy neighbour policies adopted by countries (more on
this later)
Post WWII drive for
increased global
cooperation
Features of the Bretton Woods System

• A system of adjustable peg was established

• This was a gold exchange standard where most currencies were
pegged into dollar and the dollar was pegged into gold
 • The system dissolved between 1968 and 1973. In August
1971, U.S. President Richard Nixon announced the
"temporary" suspension of the dollar's convertibility into
gold.

• While the dollar had struggled throughout most of the

1960s within the parity established at Bretton Woods, this
crisis marked the breakdown of the system. An attempt to
revive the fixed exchange rates failed, and by March 1973
Collapse of the the major currencies began to float against each other.
Bretton Woods
• Since the collapse of the Bretton Woods system, IMF
members have been free to choose any form of exchange
arrangement they wish (except pegging their currency to
gold):

• But no new global system of fixed rates was started

again.
Two major learning objectives
1. Impact of exchange rate movement on the trade balance
2. The relationship between exchange rate and interest
rates
 • A depreciation of the home currency causes foreign goods to become
more expensive (in terms of home currency), reducing consumption of
imports relative to domestic alternatives.

Exchange • A depreciation makes the home country’s exports cheaper (in terms of
foreign currency), so the trading partner switches expenditure towards
Rate and home products.

Depreciation • This process is called expenditure switching

• Whether expenditure switching will lead to an improvement in the

home country’s current account will depend upon the price elasticities
of demand for imports and exports

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Exchange Rate and
Depreciation
• Depreciation is a decrease in the value of a currency relative to another currency.

• A depreciated currency is less valuable (less expensive) and therefore can be exchanged for
(can buy) a smaller amount of foreign currency.

• If the exchange rate moves from Rs 40/$ to Rs 50/$ it means that the INR has depreciated
relative to the Dollar. It now takes Rs 50 to buy one US$, so that the INR is less valuable.

• The dollar has appreciated relative to the INR: it is now more valuable.

• Nowadays we tend to use terms ‘devaluation’ and ‘depreciation’ interchangeably. However,

strictly speaking, devaluation happens w.r.t. gold and depreciation happens w.r.t other
currencies.

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Exchange Rate and Depreciation…Scenario 1

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (in Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20,000 10 400 50 20,000 0

50 200 4 150 600 30000 10 500 30 15000 15000

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Exchange Rate and Depreciation…Scenario 2

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20000 10 400 50 20000 0

50 200 4 110 440 22000 10 500 48 24000 -2000

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Exchange Rate and Depreciation…3

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (in Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20,000 10 400 50 20,000 0

50 200 4 150 600 30000 10 500 30 15000 15000

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20000 10 400 50 20000 0

50 200 4 110 440 22000 10 500 48 24000 -2000

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 Marshall-Lerner Condition

Marshall-Lerner condition states that a depreciation of domestic

currency can improve a country’s balance of payments only when
the sum of the price elasticity of demand of exports and the price
elasticity of demand for imports exceeds unity.

 x + m  1
 • A depreciation of the home currency causes foreign goods to
become more expensive (in terms of home currency),
reducing demand of imports relative to domestic alternatives.

• A depreciation makes the home country’s exports cheaper

Exchange Rate than other suppliers in the foreign market (in terms of foreign
currency). So, in the foreign market it draws demand away
from foreign suppliers
and
Depreciation • This process is called expenditure switching

• Whether expenditure switching will lead to an improvement

in the home country’s current account will depend upon the
price elasticities of demand for imports and exports

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Sometimes devaluation is called “beggar thy neighbour” policy
As we discussed:

A depreciation of the home currency causes foreign goods to become more expensive (in terms of
home currency), reducing demand of imports relative to domestic alternatives. Therefore, this policy
discriminates against foreign producers in the domestic market

A depreciation makes the home country’s exports cheaper (in terms of foreign currency), so in the
foreign market it helps domestic producers undercut prices of other suppliers. Therefore, this policy
discriminates against foreign producers in the export market.

Basically, the belief is that a depreciation can improve a country’s (X-M)

Depreciation is sometimes called a “beggar-thy-neighbor policy”. It is called so because a depreciation

is traditionally believed to benefit the country that implements it while harming that country’s
neighbours or trading partners.

This is also the reason why we see countries retaliate against each other in the currency market and
“Currency Wars” take place

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Other Effects of depreciation
• But for the home country, depreciation can
also be inflationary
• More expensive imports
• Increased aggregate demand may become
inflationary if capacity constraints exist

• What happens if a country is highly import

dependent for its exports?
• Impact of depreciation is less

Cost of Export
production Volume of Export Revenue
Rs/$ (in Rs) Price in $ exports Revenue ($) (in Rs)

40 200 5 100 500 20,000

50 240 4.8

If imported inputs are used, then a depreciation can increase cost of 26

production as imported inputs become more expensive
Other Effects of depreciation
• But for the home country, depreciation can
also be inflationary
• More expensive imports
• Increased aggregate demand may become
inflationary if capacity constraints exist
• Sometimes devaluation is called “beggar thy
neighbour” policy
• But what happens if every country
devalues?
• depreciation increases external debt
burden of domestic players in terms of
domestic currency
Therefore, any decision to devalue a currency must depend on
the estimated net effect on depreciation.
The channels are:
 Impact through exports and its price elasticities
 Impact through imports and its price elasticities and import
intensity of domestic economy
 Impact on foreign debt held by domestic players
 Possible retaliation by competing countries
Impact on external Commercial Borrowing
(What is a natural hedge?)
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Summing up
If the Marshal-Lerner conditions are satisfied, an exchange rate
depreciation can improve a country’s trade balance

However, the positive impact of depreciation on exports will be

less if there are imported inputs in the production of exports

Also, a domestic inflation (due to say, expansionary monetary or

fiscal policy) can affect a country’s competitiveness in the export
market
Because of these, policymakers often track both nominal
exchange rate and real exchange rate of a country

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 The real exchange rate measures the
value of a country’s goods against those
of another country, at the prevailing
What is a nominal exchange rate
Real
Exchange The real exchange rate (RER) between
Rate two currencies is the nominal exchange
rate (e) multiplied by the ratio of prices
between the two countries, P/P*. The
RER therefore is eP*/P.

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 Prices of Indian goods in
Prices of Indian goods in USD (EP) using nominal
INR (P) exchange rate
Prices of Indian goods in
terms of US goods (ε =EP/P*)

Prices of US goods in USD

(P*)

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Prices of Indian goods in Prices of Indian goods in
INR (P) USD (EP)
Prices of Indian goods in
terms of US goods (ε =EP/P*)

Prices of US goods in USD (P*)

1. Real exchange rate (ε)

2. P= Price of Indian goods in INR
3. P* = Price of US goods in USD
EP
 = 4. E= nominal exchange rate in terms of units of $/INR
P *

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If a Big Mac represents the price level in India and USA
A Big Mac costs 191 rupees in India and US$5.15 in the United States.

191 Rs (191/80) $
ε = 0.46

5.15 $

In actual calculation of real

exchange rates, price levels are
captured by price indices like
CPI/WPI or GDP deflator

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Real exchange rates can vary either due to changes in nominal exchange rates or due to changes in
relative price levels

Like nominal exchange rates, real exchange rates move over time:

• An increase in the relative price of domestic goods in terms of foreign goods is called a real
appreciation, which corresponds to a decrease in the real exchange rate, .

• A decrease in the relative price of domestic goods in terms of foreign goods is called a real
depreciation, which corresponds to an increase in the real exchange rate, . 33
Nominal and real Effective Exchange Rates
Bilateral exchange rates are exchange rates between two countries. Multilateral exchange rates are exchange
rates between several countries.

https://www.rbi.org.in/Scripts/BS_ViewBulletin.aspx?Id=20020 34
appreciation

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Reading
• Please look at only the relevant sections from Chapter 18
(handout) and Chapter 19 (softcopy) of the material given
to you.

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