An exchange rate is the price of one currency expressed in terms of another currency. Exchange rates affect the prices of imports and exports, international trade, inflation, investment and the balance of payments.
For example, if US$1 = ₹85, an Indian importer needs ₹85 to purchase one US dollar, ignoring transaction costs.
Measurement of Exchange Rates
Nominal exchange rate
The nominal exchange rate is the rate at which one currency can be exchanged for another currency.
Example:
→ US$1 = ₹85
If the exchange rate changes to US$1 = ₹90, more rupees are needed to purchase one US dollar.
→ The rupee has depreciated against the US dollar.
If the exchange rate changes to US$1 = ₹80:
→ The rupee has appreciated against the US dollar.
Important: Always check how the exchange rate is quoted before deciding whether a currency has appreciated or depreciated.
Real exchange rate
The real exchange rate measures the price of foreign goods and services relative to domestic goods and services, after adjusting for price-level differences between countries.
It indicates how competitive a country’s goods are compared with foreign goods.
A commonly used formula is:
Where:
- = nominal exchange rate, measured as domestic currency per unit of foreign currency
- = foreign price level
- = domestic price level
With this convention, a rise in the real exchange rate means foreign goods have become more expensive relative to domestic goods, so domestic goods have become more price-competitive.
Example
Suppose:
- Nominal exchange rate = ₹80 per US dollar
- Price of a product in the USA = US$10
- Price of a comparable product in India = ₹600
The real exchange rate is:
The US product costs ₹800 when converted into rupees, compared with ₹600 for the Indian product.
→ The US product is more expensive than the Indian product, before considering transport costs, taxes and differences in quality.
How the real exchange rate changes
→ Domestic prices rise faster than foreign prices, with the nominal rate unchanged → domestic goods become relatively more expensive → price competitiveness falls.
→ Foreign prices rise faster than domestic prices, with the nominal rate unchanged → domestic goods become relatively cheaper → price competitiveness improves.
→ The domestic currency depreciates, with prices unchanged → domestic goods generally become cheaper relative to foreign goods.
Difference between nominal and real exchange rates
| Nominal exchange rate | Real exchange rate |
|---|---|
| Measures the exchange value of one currency against another | Adjusts the nominal exchange rate for price-level differences |
| Directly quoted in the foreign-exchange market | Calculated using the nominal rate and price levels |
| Does not account for differences in inflation | Helps assess international price competitiveness |
| Example: US$1 = ₹80 | Compares the price of foreign goods with domestic goods |
Trade-weighted exchange rate
A trade-weighted exchange rate measures the value of a country’s currency against a basket of other currencies, with each currency given a weight based on its importance in the country’s international trade.
It provides a broader measure than the exchange rate against a single currency.
Example
Suppose India trades with three countries:
| Trading partner | Share of India’s trade | Change in rupee’s value against that currency |
|---|---|---|
| USA | 50% | Depreciates by 4% |
| Euro area | 30% | Appreciates by 2% |
| Japan | 20% | Depreciates by 3% |
A simplified weighted calculation is:
In this simplified example, the rupee’s trade-weighted value falls by approximately 2.6%.
Actual trade-weighted indices use published index methods and may use geometric weighting, changing trade weights and adjustments for inflation.
Importance
→ Shows whether a currency is strengthening or weakening against its major trading partners overall.
→ Helps assess the competitiveness of exports and imports.
→ Supports analysis of inflation and the balance of payments.
→ Avoids relying only on one exchange rate, which may not represent the country’s overall trading relationships.
Determination of Exchange Rates Under Fixed and Managed Systems
Fixed exchange rate system
A fixed exchange rate system is one in which the government or central bank maintains the currency at a set value against another currency or a currency standard.
For example, a country may commit to maintaining its currency at a specified rate against the US dollar.
How a fixed exchange rate is maintained
The exchange rate may face pressure because demand for and supply of the domestic currency change in the foreign-exchange market.
When the domestic currency faces downward pressure:
→ Demand for the domestic currency falls relative to supply → The currency faces depreciation pressure → The central bank sells foreign-exchange reserves and buys domestic currency → Demand for the domestic currency increases → The central bank attempts to maintain the fixed rate.
When the domestic currency faces upward pressure:
→ Demand for the domestic currency rises relative to supply → The currency faces appreciation pressure → The central bank buys foreign currency and supplies domestic currency → The additional supply of domestic currency reduces upward pressure → The central bank attempts to maintain the fixed rate.
Other measures used to maintain a fixed exchange rate
Interest-rate changes
→ Higher interest rates may attract foreign financial investment → Capital inflows may increase demand for the domestic currency → Depreciation pressure may be reduced.
However, higher interest rates can reduce domestic consumption, investment and growth.
Restrictions on capital flows
→ Limits on certain international financial transactions may reduce destabilising capital movements → Pressure on the fixed exchange rate may be reduced.
Such restrictions can discourage investment and limit financial-market flexibility.
Fiscal and monetary policies
→ The government or central bank may reduce domestic demand and inflationary pressure → Imports may fall and the currency may face less downward pressure.
However, these policies can increase unemployment and slow economic growth.
Advantages and disadvantages of a fixed exchange rate
Advantages
→ Provides greater certainty for international traders and investors.
→ Reduces uncertainty about the future domestic-currency cost of imports and exports.
→ Can help control inflation if the currency is credibly fixed to a stable currency.
→ May encourage international trade and investment.
Disadvantages
→ Requires sufficient foreign-exchange reserves and policy credibility.
→ The central bank may have less freedom to set interest rates for domestic objectives.
→ Persistent external deficits may put pressure on reserves.
→ If the fixed rate is unrealistic, the currency may face speculative attacks.
→ Maintaining the rate may require policies that reduce growth and employment.
Managed exchange rate system
A managed exchange rate system allows market forces to influence the currency’s value, but the central bank intervenes when it considers intervention necessary.
It is also called a managed float or a dirty float.
How it works
→ Demand and supply determine much of the exchange rate.
→ The central bank may buy or sell foreign currencies to influence the rate.
→ It may also adjust interest rates or use other measures to reduce excessive volatility.
Example: If a currency depreciates rapidly and the central bank wants to limit imported inflation, it may sell foreign-exchange reserves and buy domestic currency.
Advantages
→ Allows some exchange-rate flexibility when economic conditions change.
→ Intervention may reduce excessive short-term volatility.
→ Provides more policy flexibility than a strict fixed exchange rate.
Disadvantages
→ The exchange rate may still fluctuate considerably.
→ Intervention may be ineffective against strong market pressures.
→ Foreign-exchange reserves may be depleted if intervention is sustained.
→ Uncertainty about intervention may make future exchange-rate movements harder to predict.
Fixed versus managed exchange rates
| Feature | Fixed system | Managed system |
|---|---|---|
| Exchange-rate movement | Maintained around a specified rate | Mainly market-determined, with intervention |
| Central-bank intervention | Required when necessary to defend the rate | Used selectively |
| Certainty for traders | Greater if the peg is credible | Less certainty than under a credible fixed rate |
| Monetary-policy flexibility | More limited | Generally greater, depending on the degree of management |
| Reserve requirements | May need substantial reserves to defend the rate | Reserves may be used to influence the rate |
| Response to external shocks | Adjustment may require internal economic changes or a change in the peg | Exchange rate can adjust, with intervention to moderate movements |
Revaluation and Devaluation of a Fixed Exchange Rate
Revaluation
Revaluation is an official increase in the value of a currency under a fixed or managed exchange-rate system.
Example:
→ The government changes the official rate from US$1 = ₹85 to US$1 = ₹80.
Under this quotation, the rupee has been revalued because fewer rupees are needed to purchase one US dollar.
Effects
→ Imports become cheaper in domestic currency.
→ Imported raw materials and fuel may become cheaper.
→ Inflationary pressure may fall.
→ Domestic exports become more expensive for foreign buyers.
→ Export competitiveness may weaken.
→ Import demand may rise and export demand may fall, potentially worsening the current account.
Reasons for revaluation
→ Persistent balance of payments surpluses or sustained upward pressure on the currency.
→ Reducing imported inflation.
→ Making imported capital goods cheaper.
Limitations
→ Export-oriented firms may lose sales.
→ Employment may fall in industries facing stronger foreign competition.
→ The current account may deteriorate if trade flows respond strongly to price changes.
Devaluation
Devaluation is an official reduction in the value of a currency under a fixed or managed exchange-rate system.
Example:
→ The government changes the official rate from US$1 = ₹85 to US$1 = ₹90.
Under this quotation, the rupee has been devalued because more rupees are needed to purchase one US dollar.
Effects
→ Exports become cheaper in foreign currency.
→ Imports become more expensive in domestic currency.
→ Export demand may increase.
→ Import demand may decrease.
→ The current account may improve.
→ Imported fuel, food and raw materials become more expensive, potentially increasing inflation.
Reasons for devaluation
→ Correcting a persistent current account deficit.
→ Improving export competitiveness.
→ Reducing excessive demand for imports.
→ Responding to a fixed rate that is judged to be overvalued.
Limitations
→ Imported inflation may increase.
→ Firms relying on imported inputs may face higher costs.
→ Foreign-currency debt becomes more expensive to repay in domestic currency.
→ The current account may initially worsen before improving.
Revaluation versus devaluation
| Revaluation | Devaluation |
|---|---|
| Official increase in currency value | Official decrease in currency value |
| Imports become cheaper | Imports become more expensive |
| Exports become more expensive to foreign buyers | Exports become cheaper to foreign buyers |
| May reduce imported inflation | May increase imported inflation |
| May weaken export competitiveness | May improve export competitiveness |
| May worsen the current account | May improve the current account, depending on elasticities |
Important distinction: Appreciation and depreciation describe market-driven exchange-rate changes, typically under floating systems. Revaluation and devaluation refer to official changes in a fixed or managed rate.
Changes in the Exchange Rate Under Different Systems
Floating exchange rate system
Under a floating system, the exchange rate is determined mainly by demand and supply in the foreign-exchange market.
Factors increasing demand for the domestic currency
→ Foreign demand for domestic exports rises → Foreign buyers need more domestic currency → Demand for the domestic currency rises → The currency appreciates, other things being equal.
Other factors include higher relative interest rates, increased foreign investment and greater confidence in the domestic economy.
Factors increasing supply of the domestic currency
→ Domestic consumers purchase more imports → They supply more domestic currency to obtain foreign currency → Supply of the domestic currency rises → The currency depreciates, other things being equal.
Other factors include increased domestic investment abroad and reduced foreign demand for domestic assets.
Advantages of a floating exchange rate
→ The exchange rate can adjust to changes in demand and supply.
→ The central bank does not have to maintain a specific exchange rate.
→ Monetary policy can focus more on domestic objectives, subject to other economic constraints.
Disadvantages
→ Exchange-rate uncertainty may discourage trade and investment.
→ Depreciation can increase imported inflation.
→ Appreciation can reduce export competitiveness.
→ Rapid capital flows and speculation may cause volatility.
Fixed exchange rate system
Under a fixed system, the market may create pressure for the currency to move, but the central bank attempts to maintain the official rate.
→ Excess demand for the domestic currency → central bank may buy foreign currency and supply domestic currency.
→ Excess supply of the domestic currency → central bank may sell foreign currency and buy domestic currency.
If pressure persists, the central bank may need to change interest rates, use reserves, introduce restrictions or alter the official rate.
Managed exchange rate system
Under a managed system, market forces determine the exchange rate within the central bank’s chosen approach to intervention.
→ Temporary downward pressure → the central bank may sell foreign currency to support the domestic currency.
→ Excessive upward pressure → the central bank may buy foreign currency to limit appreciation.
→ Persistent market pressure → the central bank may allow the exchange rate to adjust rather than continually intervening.
Comparison of exchange-rate changes
| Change in conditions | Floating system | Fixed system | Managed system |
|---|---|---|---|
| Demand for exports rises | Currency tends to appreciate | Central bank intervenes if needed to maintain the rate | Currency may appreciate unless intervention limits the movement |
| Domestic demand for imports rises | Currency may face depreciation pressure | Central bank may defend the rate using reserves or policy changes | Central bank may intervene or allow some depreciation |
| Foreign investment inflows rise | Currency tends to appreciate | Intervention may be required to maintain the peg | Central bank may buy foreign currency to moderate appreciation |
| Persistent downward pressure | Currency generally depreciates | Reserves or policy changes may be needed; devaluation is possible | Central bank may intervene or allow depreciation |
Effects of Changing Exchange Rates on the External Economy
A change in the exchange rate affects export and import prices, the current account, inflation, economic growth and employment.
Effects of depreciation
→ Domestic currency depreciates → Domestic exports become cheaper for foreign buyers → Imported goods become more expensive for domestic buyers → Export demand may rise and import demand may fall → Net exports may improve → Aggregate demand may increase → Output and employment may rise.
However:
→ Imported fuel and raw materials become more expensive → Firms’ production costs rise → Domestic prices may increase → Inflation may rise.
Depreciation therefore may improve the current account but also create inflationary pressure.
Effects of appreciation
→ Domestic currency appreciates → Exports become more expensive for foreign buyers → Imports become cheaper for domestic buyers → Export demand may fall and import demand may rise → Net exports may deteriorate → Aggregate demand and employment may fall in export-oriented industries.
However:
→ Imported goods and raw materials become cheaper → Firms’ costs may fall → Inflationary pressure may weaken → Consumers gain purchasing power over imported goods.
The overall effect depends on the importance of exports and imports in the economy, the responsiveness of demand, production capacity and the time period considered.
Marshall–Lerner Condition
The Marshall–Lerner condition explains when a depreciation or devaluation of a currency is likely to improve the trade balance.
It states that, under the standard assumptions of the model, depreciation improves the trade balance when the sum of the absolute price elasticities of demand for exports and imports is greater than one.
Where:
- = price elasticity of demand for exports.
- = price elasticity of demand for imports.
When the condition is satisfied
Suppose:
- Absolute PED for exports = 0.8
- Absolute PED for imports = 0.6
The Marshall–Lerner condition is satisfied.
→ Depreciation makes exports cheaper to foreign buyers → Export demand rises significantly → Depreciation makes imports more expensive to domestic buyers → Import demand falls significantly → The trade balance is likely to improve after adjustment.
When the condition is not satisfied
Suppose:
- Absolute PED for exports = 0.3
- Absolute PED for imports = 0.4
The condition is not satisfied.
→ Export and import quantities respond relatively weakly to price changes → The value of imports may rise because they cost more in domestic currency → Export receipts may not rise sufficiently → The trade balance may worsen rather than improve.
Factors affecting the effectiveness of depreciation
→ Availability of domestic substitutes for imports.
→ Availability of alternative suppliers for foreign buyers.
→ Whether domestic firms have spare capacity to increase exports.
→ The proportion of imported inputs used in domestic exports.
→ Time available for consumers and firms to adjust.
→ Price elasticity of demand for exports and imports.
Limitation: The Marshall–Lerner condition focuses on trade-price elasticities under simplifying assumptions. The overall current account also includes services, primary income and secondary income.
The J-Curve Effect
The J-curve effect explains why depreciation may initially worsen the trade balance before improving it over time.
Immediately after depreciation, the quantities of exports and imports may not change much because contracts, habits and supply arrangements take time to adjust. However, the domestic-currency price of imports rises.
Short-run effect
→ Domestic currency depreciates → Imported goods become more expensive in domestic currency → Import quantities change only slightly at first → The total domestic-currency cost of imports may rise → Export quantities may also respond slowly → The trade balance may initially worsen.
Long-run effect
→ Consumers find domestic substitutes for imported goods → Firms change suppliers or production methods → Foreign buyers respond to lower export prices → Export quantities rise and import quantities fall → The trade balance may improve.
The path of the trade balance resembles the letter J: an initial decline followed by an improvement.
Example
A country imports most of its oil and has contracts that cannot be changed immediately.
→ Its currency depreciates → The domestic-currency cost of oil rises quickly → Import quantities remain almost unchanged in the short run → The trade balance worsens initially.
Later:
→ Domestic firms and households adjust their spending → Exporters increase production if capacity allows → Import quantities may fall and export quantities may rise → The trade balance may improve.
Limitations of the J-curve model
→ The trade balance does not always follow a J-shaped pattern.
→ The outcome depends on price elasticities and the size of the depreciation.
→ Exporters may rely heavily on imported raw materials, so depreciation may increase their costs.
→ Weak foreign demand may prevent export volumes from rising.
→ A large depreciation may increase inflation and reduce the initial competitiveness benefit.
Overall Evaluation
The effectiveness of exchange-rate changes depends on the exchange-rate system, the cause of the external imbalance and the responsiveness of trade flows.
- Marshall–Lerner condition: helps assess whether the price responsiveness of exports and imports is sufficient for depreciation to improve the trade balance.
- J-curve effect: explains why the trade balance may deteriorate initially even if it improves in the long run.
- Fixed exchange rates: provide greater certainty but may require reserves and difficult policy adjustments.
- Floating exchange rates: adjust automatically to market conditions but can create volatility.
- Managed exchange rates: allow some flexibility, but intervention may be costly and cannot always prevent persistent market pressure.
Conclusion: Exchange-rate policy can influence a country’s external competitiveness, but a depreciation or devaluation does not guarantee an improved balance of payments. Its success depends on trade elasticities, domestic productive capacity, imported-input dependence, inflation and the time required for consumers and firms to adjust.