Exchange rates: Measurement, Determination, Fixed and Managed Systems

Vocabulary flashcards covering measurement, real vs nominal exchange rates, trade-weighted indices, and fixed/managed exchange rate mechanisms with their determiners and implications.

Nominal exchange rate

The price of one currency in terms of another; e.g., 20 South African Rand buys 1 US dollar.

Real exchange rate

A currency’s value in terms of its real purchasing power, accounting for price changes and exchange-rate changes to assess competitiveness.

Real exchange rate formula

Real exchange rate = (nominal exchange rate × domestic price index) / foreign price index.

Trade-weighted exchange rate

An index of the price of a currency against a basket of currencies, weighted by the relative importance of trading partners.

Measurement methods for exchange rates

Prices can be measured as cost in another currency, what it buys in other countries, or against a basket of currencies.

Fixed exchange rate system

An exchange rate set by the government and maintained by the central bank; e.g., 1 dirham = US$0.25 for the UAE.

Direct intervention

Central bank buys or sells the currency to influence the exchange rate.

Interest rate channel

Central bank changes the interest rate to attract funds (hot money), causing currency appreciation or depreciation.

Disadvantages of fixed exchange rate

Requires sizeable reserves and incurs opportunity costs; may force sacrifice of other policy objectives; risk of running out of reserves and needing devaluation/revaluation.

Advantages of fixed exchange rate

Creates certainty for trade and investment and imposes discipline on inflation to maintain price competitiveness.

Managed exchange rate (managed float)

A system where the rate is allowed to move by market forces within a band; government intervenes to keep it within limits.

Exchange-rate band (upper and lower limits)

An upper limit Pa and lower limit Pb around a central value P within which the rate is allowed to move; Pc is a central value where no action is taken.

Central bank action within a managed band

If demand pushes the rate toward a band limit, the central bank intervenes, e.g., by selling currency to keep the rate within the band.

Effect of real exchange rate on the trade balance

A higher real exchange rate makes domestic goods relatively more expensive, reducing exports and increasing imports, affecting the current account more than the nominal rate.

Long-run equilibrium value

The exchange rate level toward which the fixed-rate system is easier to maintain if the rate is near its long-run equilibrium value.