IV. Stabilization policy
B. Foreign exchange markets
1. Exchange rates (ERs)
(2) Real exchange rates (R)

Exchange rates worksheet - key

Note: you have to convert to some common currency to compare prices, but it doesn't matter which currency you use.

    Real exchange rate (R) measures competitiveness
    Real depreciation => increased competitiveness
    Real appreciation => decreased competitiveness

    Example: Real depreciation of 10% =>
    From US perspective, all foreign tradables (both importables and exportables) look 10% more expensive to us than before.
    From foreign perspective, all U.S. tradeables look 10% cheaper than before.
    Overall: The US gains competitiveness in world markets.

2 ways to calculate the percentage change in R over time:

    General rule: An x% real depreciation of a currency has the same effects as a simultaneous x% import tariff and x% export subsidy.
    An x% real appreciation has the same effects as a simultaneous x% import subsidy and x% export tax

    People seem to like both a strong currency and a trade surplus.
    Hard to have both at the same time

(3) Effective exchange rates

    Effective exchange rate (Multilateral exchange rate): an index giving a trade-weighted average value of domestic currency
    For the US: gives a value of the dollar weighted against a representative basket of foreign currencies.
    In theory: Each currency weighted by its importance to The US in international trade.
    Ex: U.S.: large weight to Canada and Japan; small weight to G and Fr
    Given as both nominal and real.

2. Exchange rate arrangements
    Floating vs. fixed ERs

    Government chooses an exchange rate arrangement (IMF Annual Report Appendixes financial operations and transactions appendix--appendix Table II.9)

    Option 1: floating ERs: market-determined
    Depreciation = Currency value falls (lower ER value of domestic currency)
    Appreciation = Currency value rises (higher ER value of domestic currency)

    Traders and savers compete with each other for foreign exchange

    Option 2: fixed ERs: government-determined
    Devaluation = Government lowers its currency value
    Revaluation = government raises its currency value

    Traders and savers do not compete for foreign exchange--they can just turn to the government as a residual buyer and seller of foreign exchange to keep its ER stable

    Which to choose?
    There is no one right answer:
    Advantages to floating ERs:
    --Policy autonomy--your government has one less constraint to worry about
    --Allows FX markets to adjust quickly

    The major players in today's global economy usually let the free market set the value for their currencies => floating exchange rates
    If it is always best to have floating, why not have separate currencies in CA and NV and let the ER float--single currency, like the euro is an extreme case of fixed ERs

    Advantages to fixed ERs:
    --Greater day-to-day ER stability
    --Central Bank discipline--can't inflate your economy's money supply because you have to contract it back to keep your ER stable
    Disadvantages: 
    --must stockpile foreign exchange
    --risk periodic crises

    current ERs handout

    Who chooses floating ERs?
    Large countries with relatively small foreign sectors tend to choose floating exchange rates

    Who chooses fixed ERs? 
    Small countries with relatively large foreign sectors tend to choose fixed ERs, preferably with their top trading partner
    Ex: Denmark pegs to the Euro
    Also: countries with a history of excessive inflation that want to re-establish credibility in their control of prices
    Ex: Zimbabwe -- no legal tender currently (uses several foreign currencies such as the dollar.
    ER = a "nominal anchor"