Exchange rates influence a country’s international competitiveness, trade flows, inflation, and overall economic performance. This topic explores exchange rate systems, key determinants, and policy implications.
Types of exchange rate systems
Floating exchange rates
A floating exchange rate system allows the value of a currency to be determined entirely by market forces—namely supply and demand for the currency in the foreign exchange (forex) market. The government or central bank does not set a target value for the currency, nor does it engage in regular intervention. The currency can appreciate or depreciate freely based on economic indicators, investor confidence, and global events.
Key features of floating exchange rates:
Market-determined: The exchange rate fluctuates in response to trade flows, interest rate differentials, speculation, and capital movements.
Exchange rate volatility: Prices can be highly volatile, which can discourage trade and investment if movements are unexpected or erratic.
Automatic correction: A trade deficit can lead to depreciation, making exports cheaper and imports more expensive, eventually helping to restore balance.
Advantages:
Allows a country to maintain independent monetary policy—for example, setting interest rates to suit domestic needs.
Automatically adjusts to external shocks or imbalances.
Avoids the need for large reserves of foreign currency.
Disadvantages:
Risk of speculative attacks and currency volatility.
Can cause uncertainty for businesses and investors engaged in international trade.
May worsen inflation if the currency depreciates rapidly.
Fixed exchange rates
In a fixed exchange rate system, a country pegs its currency to another currency (commonly the US dollar or euro) or a basket of currencies. The government or central bank commits to maintaining this rate, usually through active market intervention and maintaining sufficient reserves.
How it works:
If the currency is under upward pressure, the central bank sells its own currency and buys foreign reserves to prevent appreciation.
If the currency is under downward pressure, it sells foreign reserves and buys domestic currency to support its value.
Advantages:
Stability in trade and investment decisions due to reduced exchange rate risk.
Helps maintain low inflation by anchoring the currency to a stable reference.
Enhances policy credibility, especially in countries with histories of high inflation or poor monetary control.
Disadvantages:
Requires large foreign currency reserves to maintain the peg.
Limits monetary policy independence—interest rates must often follow those of the anchor currency country.
Pegs can become unsustainable if the underlying economy diverges significantly from the anchor country.
Managed float (dirty float)
A managed float is a hybrid system where the currency is mainly determined by market forces, but the central bank intervenes occasionally to influence the exchange rate without committing to a fixed level. This might be done to:
Reduce short-term volatility,
Prevent speculative bubbles,
Correct misalignments with economic fundamentals.
Managed floats are common in economies that want to benefit from both flexibility and stability.
Revaluation vs appreciation / devaluation vs depreciation
Appreciation vs revaluation
An appreciation occurs in a floating exchange rate system when a currency increases in value relative to another due to market forces. For example, if £1 = 1.30, the pound has appreciated.
A revaluation occurs in a fixed exchange rate system when the government deliberately raises the fixed exchange rate. For instance, if the government changes the peg from £1 = 1.30, this is a revaluation.
Impacts of appreciation and revaluation:
Exports become more expensive, potentially reducing demand from foreign buyers.
Imports become cheaper, helping control inflation but potentially harming domestic producers.
May reduce economic growth due to falling net exports.
Depreciation vs devaluation
A depreciation occurs in a floating exchange rate system when a currency falls in value. For example, if £1 = 1.10, the pound has depreciated.
A devaluation occurs in a fixed system when the government lowers the fixed value of its currency. For example, changing the peg from £1 = 1.10.
Impacts of depreciation and devaluation:
Exports become cheaper, which can increase demand and boost GDP.
Imports become more expensive, increasing inflationary pressures.
Can improve the current account if the Marshall-Lerner condition holds.
Factors influencing floating exchange rates
Interest rates
Higher domestic interest rates tend to attract foreign capital as investors seek higher returns. This increases demand for the currency, leading to appreciation. Conversely, lower interest rates reduce attractiveness, leading to depreciation.
Interest rates also affect speculation—expectations of future rate changes can trigger immediate currency movements.
Inflation
Countries with low inflation rates typically experience currency appreciation as their goods remain competitive and attractive to foreign buyers. High inflation reduces purchasing power, discourages investment, and can lead to currency depreciation.
Speculation
Traders and investors in foreign exchange markets often act on expectations about future economic performance, interest rate changes, or political events.
If investors expect a currency to strengthen, they will buy it, causing appreciation.
If uncertainty or poor economic prospects loom, they may sell, causing depreciation.
Balance of payments
The current account balance affects currency demand:
A current account surplus implies strong demand for exports, increasing demand for the currency and leading to appreciation.
A deficit increases demand for foreign currency to pay for imports, leading to depreciation.
The capital and financial accounts also influence currency flows, especially with large foreign investment inflows or outflows.
Government intervention in exchange rates
Foreign currency purchases and sales
Central banks intervene in the forex market to buy or sell currencies to influence exchange rate movements:
To support a depreciating currency, the central bank sells foreign currency reserves and buys the domestic currency to increase its demand.
To weaken an appreciating currency, the central bank sells domestic currency and buys foreign currency to increase supply and reduce value.
This tool is common in managed float and fixed systems, but less so in freely floating systems.
Interest rate policy
By raising or lowering interest rates, central banks can influence the flow of capital and hence the value of the currency:
Raising interest rates attracts foreign capital and strengthens the currency.
Lowering interest rates may weaken the currency but can stimulate domestic demand.
This method may conflict with other macroeconomic goals, such as controlling inflation or supporting employment.
Competitive devaluation / depreciation
Definition and objectives
Competitive devaluation occurs when countries deliberately weaken their currencies to gain a trade advantage. This is typically done to:
Increase export competitiveness by making goods cheaper internationally,
Support domestic employment and output,
Improve the current account balance.
This strategy can be pursued through:
Direct currency market intervention,
Expansionary monetary policy (e.g. cutting interest rates),
Deliberate devaluation in fixed systems.
Benefits
Boosts net exports, increasing aggregate demand.
Stimulates economic growth and employment in export-oriented sectors.
Helps reduce trade deficits, particularly when exports and imports are price elastic.
Drawbacks
Can lead to inflation, as import prices rise and wage demands increase.
May provoke retaliation from trade partners—if several countries devalue simultaneously, the benefits are cancelled, and currency wars can ensue.
Creates uncertainty for investors and trading partners.
Impacts of exchange rate changes on the macroeconomy
Current account and the Marshall-Lerner condition
The Marshall-Lerner condition states that a depreciation or devaluation will improve the current account only if:
PEDx + PEDm > 1
Where:
PEDx = price elasticity of demand for exports
PEDm = price elasticity of demand for imports
If this condition is met, export revenue will rise and import spending will fall, improving the trade balance.
The J-curve effect
Following a depreciation:
In the short run, the current account may worsen due to inelastic demand and fixed trade contracts.
Over time, as demand becomes more elastic and buyers adjust, the current account improves.
Graphically, this appears as a J-shaped curve, showing worsening before improvement.
Growth and employment
Depreciation can increase aggregate demand via higher exports and reduced imports. This boosts:
Output: Export industries expand due to higher foreign demand.
Employment: More jobs are created in trade-related sectors.
Multiplier effects: Increased spending can lead to secondary rounds of economic expansion.
However, effects depend on the elasticity of demand, the state of the global economy, and domestic production capacity.
Inflation
Depreciation increases the cost of imports, such as oil, food, and raw materials, contributing to:
Cost-push inflation: Higher input costs passed onto consumers.
Demand-pull inflation: Export-led growth increases demand pressures.
Imported inflation: Direct rise in the price of foreign goods and services.
Appreciation, in contrast, can help reduce inflation by making imports cheaper and applying downward pressure on domestic prices.
Foreign direct investment (FDI)
Exchange rates influence FDI flows in several ways:
A weaker currency makes domestic assets cheaper for foreign investors, potentially increasing FDI inflows.
However, high volatility or risk of sudden depreciation can deter long-term investors who value stability.
A stable and competitive currency is generally preferred for attracting FDI, especially in capital-intensive sectors.
Exchange rate policy thus plays a significant role in shaping a country's attractiveness to global investors.
FAQ
A managed float offers a balance between flexibility and stability. Countries often adopt this system to allow market forces to generally determine the exchange rate while retaining the option to intervene if needed. A purely floating system can lead to excessive volatility, which creates uncertainty for businesses, investors, and consumers. This is particularly risky for developing economies or those reliant on exports. In contrast, fixed systems provide stability but restrict monetary policy freedom and require large foreign exchange reserves to maintain the peg. A managed float allows a country to influence its exchange rate to counteract short-term shocks, speculative pressures, or misalignments with economic fundamentals without committing to a rigid target. Central banks can intervene through open market operations or interest rate changes to smooth fluctuations, especially during periods of capital flight or sudden appreciation. This system supports competitiveness, avoids persistent imbalances, and retains policy autonomy, making it a pragmatic choice for many economies.
Exchange rate changes can significantly impact income distribution, often creating winners and losers across different groups. A depreciation tends to benefit exporters, as their goods become more competitively priced abroad, boosting revenues and potentially wages in those sectors. However, it can harm consumers and import-dependent businesses, particularly lower-income households that spend a larger proportion of their income on imported goods like food and fuel. Higher import prices due to depreciation can raise the cost of living disproportionately for these groups. Similarly, industries relying on imported raw materials face higher input costs, possibly leading to job cuts or wage stagnation. Conversely, an appreciation may lower inflation and benefit consumers through cheaper imports but can reduce the competitiveness of manufacturing and export sectors, leading to job losses and wage suppression. The overall effect on income distribution depends on the structure of the economy and the extent to which sectors are exposed to international trade.
Yes, a persistently strong currency can have several long-term negative effects. While it can keep inflation low by making imports cheaper and encouraging price discipline, it may also reduce export competitiveness. Domestic producers may struggle to sell goods abroad due to relatively high prices, leading to a fall in export volumes, reduced output, and job losses in export-reliant industries. Over time, this can contribute to deindustrialisation, particularly in manufacturing. A strong currency may also deter foreign direct investment, as operating costs become higher for foreign firms. Additionally, domestic firms may relocate production overseas to maintain price competitiveness, affecting the labour market. If the strength of the currency is driven by speculative flows rather than economic fundamentals, it may also increase the risk of sudden capital outflows and volatility. Therefore, while short-term benefits exist, an overvalued currency can undermine a country’s economic structure and balance of payments in the long run.
Expectations and investor confidence are critical in determining exchange rates, especially in floating or managed float systems. Currency markets are forward-looking; traders and investors base their decisions on anticipated changes in economic indicators, policy directions, political stability, and global events. For example, if investors expect a country to raise interest rates, capital inflows may increase in anticipation of higher returns, causing the currency to appreciate even before the rate change occurs. Similarly, expectations of political turmoil, recession, or fiscal mismanagement can lead to capital flight and currency depreciation. Confidence also affects the credibility of government and central bank policy—if investors trust that inflation will remain low and debt will be managed prudently, they are more likely to invest, supporting the currency. Sudden changes in sentiment can trigger rapid exchange rate movements, often out of proportion with actual data, highlighting the speculative nature of currency markets and the importance of maintaining stable and credible economic governance.
The nominal exchange rate refers to the rate at which one currency can be exchanged for another in current market conditions—e.g., £1 = $1.25. The real exchange rate, however, adjusts the nominal rate for relative price levels between countries. It reflects the purchasing power of one currency compared to another and is calculated using the formula:
Real exchange rate = (Nominal exchange rate × Domestic price level) / Foreign price level. This distinction is crucial because the nominal rate alone may not accurately indicate a country’s true international competitiveness. A country may have a stable or even depreciating nominal rate, but if its domestic inflation is high relative to trading partners, its real exchange rate may appreciate, making exports more expensive in real terms. Conversely, falling domestic prices can lead to a real depreciation even with a stable nominal rate. Policymakers and businesses monitor real exchange rates to assess competitiveness, set wage policies, and forecast trade and investment decisions.
Practice Questions
Explain two effects of a depreciation in a country’s exchange rate on its current account balance.
A depreciation makes exports cheaper and imports more expensive. This can lead to an increase in export revenue and a reduction in import spending, potentially improving the current account. However, this depends on the price elasticity of demand for exports and imports. If demand is elastic, the value of exports will rise significantly and import spending will fall, improving the trade balance. In the short term, due to existing contracts and inelastic demand, the current account may worsen before improving, as explained by the J-curve effect. Therefore, the impact depends on time and demand responsiveness.
Evaluate the likely impact of an appreciation of the pound on the UK economy.
An appreciation makes UK exports more expensive and imports cheaper. This could reduce export competitiveness, worsening the current account and potentially leading to lower economic growth and job losses in export-driven sectors. However, cheaper imports may reduce inflationary pressure, benefiting consumers and firms reliant on imported inputs. Additionally, appreciation can help the Bank of England control inflation without raising interest rates. The net effect depends on export elasticity, the structure of the economy, and global demand. While inflation may fall, reduced competitiveness and slower growth could harm employment and investment in the long term.
