exchange rate

exchange rate

1. rate at which a currency can be converted into another currency

2. nominal ER

   • prive of one currency in terms of another

3. effective ER

   • value of a currency agaisnt a basket of currencies
   • weight accorded to each currency depends on the proportion of trade done with the country

4. real ER

   • adjusted for inflation

5. floating exchange rate

   • allowed to find own level in market
   • fluctuates according to changes in DD and SS
   • reasons for shifts
     • change in price of domestic and foreign goods
       • relate to inflation
     • interest rate
     • changes in BOP
     • investment conditions
     • income
     • speculation

6. fixed exchange rate

   • fixed in terms of other countries' currency (pegging)
   • using reserves

7. comparing

   • in favour of floating
     • automatic correction of CA deficit
     • greater freedom to persue domestic policies
     • reduces need for official reserves
     • protection from inflation abroad
   • argument against floating
     • uncertainty
       • reduces investment
     • encourages destablilisng speculation

8. prushasing power parity

   • long run, ER changes in line with different inflation rates between different countries
   • ER changes to relfect relative rise or fall of purchaisng power
   • ER should adjust to equalise the price of a basket of g and s across al countries
     • PPP exist only when same basket of goods cost exaxtly the same in between countries habing considered the differences in ER