Prepared for Principles of Economics, University of the West Indies, Mona. © Damien King, November 2014.
Many economic activities in an economy require transactions with
Foreign Exchange
Foreign currency needed to carry out
international transactions.
An increasing amount of economic
activity crosses international boundaries.
other countries. We drive in buses that were manufactured in and
imported from Europe or Japan; sell agricultural produce and
minerals to the United States; eat at fast-food outlets that are
franchises of American companies; maintain bank accounts in
foreign countries; and receive remittances from family or friends
living abroad.
All of these activities are not, in principle, different from those
which occur between regions of the same country. City dwellers
consume produce grown in the country; rural folk may buy life
insurance from a financial institution headquartered in the capital
city. When the transaction has to cross a national border, however,
there often has to be an exchange of currencies as well. French
vintners don’t usually accept Myanmar kyat in exchange for their
wine. We refer to the foreign currency that people need to carry out
international transactions as foreign exchange.
INTERNATIONAL TRANSACTIONS
All the types of economic activities in which we normally engage in
our local economies can cross international borders: the purchase
and sale of goods and services, cash transfers, and the acquisition
and disposal of fixed and financial assets. We can organize these
transactions into convenient categories.
The most visible form of international economic transaction is the
trade in tangible goods. Manufactures, agricultural produce, and
mineral ore originate in one country and are used in others. While
rice is grown in commercial quantities in only a handful of
countries (Guyana, Japan, China, Thailand, India, The Philippines,
amongst a few others), it is consumed worldwide. Again, perhaps a
dozen countries manufacture automobiles, but they are used in
every country. Goods produced abroad and used at home are called
imports; those produced locally and shipped abroad are exports.
Countries also trade services. Local insurance companies may buy
re-insurance policies from larger entities in the United States or the
European Union, while local hotels provide the service of
1
accommodation to tourists and business travelers from other
abroad. One type of trade in services that has become increasingly
popular (and, in some quarters, contentious) is the trade in
business processes, such as customer service, accounting, database
maintenance, and data entry – so-called “outsourcing”, that is
carried out in the Caribbean, Africa, and India for customers in the
United States and Britain. Other traded services include shipping,
entertainment, and education.

Another source of international transactions is current transfers –

payments that are not in exchange for goods, services or assets. For
many countries, the most visible and largest transfer is remittances.
Remittances, often sent through Western Union or a similar money
transfer service from, say, the United States, the United Kingdom, or
Saudi Arabia is the largest or nearly the largest source of foreign
exchange earnings in many countries. Guatemala, Poland, Morocco,
and Vietnam are all large recipients. Remittances originate mostly
from family members who have migrated either permanently or on
temporary work programmes. Other current transfers include
profits earned by investments abroad and remitted to home
countries and foreign aid donated by wealthy countries to
governments and organizations in poorer ones.

Foreign direct investment (FDI) describes the acquisition of fixed,

productive assets in one country by residents of another. Total S. A.
of France owns petrol stations throughout Latin America; Sandals
of Jamaica owns hotels in the rest of the Caribbean; Lenovo of China
owns administrative offices and research facilities in North
America; Intel of the United States manufactures in Costa Rica,
Malaysia, and Vietnam. The country selling the asset or is the
recipient of the investment refers to it as inward FDI; the
purchasing country classifies it as outward FDI. Foreign direct
investment flows are massive, amounting to nearly US$1½ trillion
worldwide in 2012 and the evidence of it can be seen in the signage
of global firms all over the world, for the likes of McDonald’s,
Holiday Inn and Santander.

Residents of one country also buy and sell financial assets, such as
stocks and bonds. For one example, pension and mutual funds
based in North America, the United Kingdom, and Europe often buy
shares of companies in emerging markets and developing countries
as part of their portfolio of investments. It is also common for
investors in one country to purchase bonds, called sovereign bonds,
issued by foreign governments. Local residents who maintain bank
accounts abroad are yet another example of an international
financial asset transaction. All such acquisitions are referred to as
portfolio investments.

2

Balance of Payments
The official record of a country’s
international transactions.
Figure 1: The Structure of the Balance of
Payments
The final category of international transactions is the acquisition
and sale of official reserves by a country’s central bank. The net
international reserves are usually held in United States dollars, but
some is also held in euros, British pounds, and Japanese yen. In
2012, for example, the Brazilian central bank was holding the
equivalent of some US$380 billion in official reserves. Whenever
central banks acquire or dispose of reserves, there is an
international currency transaction.
The Balance of Payments
All of a country’s external economic dealings, such as the ones
outlined above, are accounted for in its balance of payments – the
official record of a country’s international transactions. If the
transaction generates an inflow of foreign exchange to the country,
it is deemed a credit; if it results in an outflow of foreign exchange,
it is recorded as a debit.
Exports of goods earn foreign exchange and so are a credit in the
balance of payments while imports require an outflow of foreign
exchange and are therefore a debit. The difference between the
values of exports and of imports of goods is referred to as the
merchandise trade balance or more simply as the trade balance (and
sometimes as net exports). Popular references to a country’s trade
deficit are referring to this balance. If credits exceed debits, a
balance is said to be in surplus; otherwise, there is a deficit.
When credits and debits that arise from trade in services are added
to those for trade in goods, the resulting figure is the balance on
goods and services. (See the structure of the balance of payments in
Error! Reference source not found. for a schematic view.) To the
previous balance, if we go on to include net current transfers, the
difference between those into and out of a country, we get the
current account balance. This balance reflects the net balance of all
current transactions, that is, transactions that do not give rise to a
future claim by the residents of one country against another. When
people make reference to the state of the balance of payments, they
are often referring only to the current account.
Changes in the ownership of existing assets appear in the capital
account,1 which consists of all the flows of foreign direct
investment, cross-border portfolio and other investment, along
with changes in official foreign reserves. The residual after the
debits are subtracted from the credits is the capital account balance.
A typical example of a balance of payments account, that for Costa
Rica, is presented in Table 1.
3

Goods, Credit (Exports)
Goods, Debit (Imports)
Trade Balance
Services, Credit
Services, Debit
Services Balance
Goods & Services Balance
Transfers, Credit
Transfers, Debit
Net Transfers
Other (net)
Current Account
Direct Inv., asset acquisition
Direct Inv., liability incurrence
Net Foreign Direct Invest.
Portfolio, Net asset acquisition
Portfolio, Net liability incurrence
Net Portfolio Investment
Other Investment Net
Reserve Assets
Errors and Omissions
Other
Other (including Reserves)
Financial Account
Capital Account, Net
Table 1: Balance of Payments Accounts,
2011, Costa Rica, US$m.
Balancing the Payments
The balance of payments account is a budget statement for a
country vis-à-vis the rest of the world. It records all the payments
between the residents of the country and those outside of its
geographic borders. Thus, from a purely accounting perspective,
debits have to match credits. Any discrepancy between inflows and
4,932 outflows are matched by a corresponding change in some financial
11,868 asset, thus ensuring that the accounts are balanced.
-6,935
6,644 This budget for the whole country imposes a binding constraint on
1,624 foreign exchange flows just as how your household budget imposes
5,021 a limit on the spending of the household. Without depleting its
-1,914 savings or borrowing money, a household’s monthly spending
1,023
cannot for long exceed the total of its earnings and asset sales.
1,907
Similarly, in the absence of depleting its reserves or international
-885
borrowing, the foreign exchange spent by a country is limited by its
604
foreign exchange earnings and FDI and portfolio inflows.
-2,195
58 Since the sum of all the debits and credits in the overall balance of
2,176
payments must be zero, it follows that, having dichotomized the
2,118 accounts into current and capital accounts, then the balance on any
-259
one of those two must be matched by an equal but opposite balance
5
on the other. In other words, if there is a deficit on the current
263
account, there must be a surplus of equal size on the capital
-203
132
account. The foreign exchange to finance a current account deficit,
-279 for example, must be coming from somewhere. Alternatively, if the
185 country has experienced a capital account surplus, then the surplus
-165 money must have gone somewhere, and that somewhere is
2,217 necessarily to fund the excess of outflows over inflows in the
-22 current account.
Notwithstanding the ex ante equality of inflows and outflows, since
the decisions to import, export, send remittances, keep a foreign
bank account, and invest abroad are all made independently by
different people, there is no a priori reason why, at any particular
exchange rate, desired inflows have to match desired outflows.
A country’s policy-makers can choose to peg their exchange rate to
a major currency, say, the U.S. dollar or the Euro, fixing the Commented [DK1]: Seems like a different topic.
exchange rate at a particular level. In such a case, the central bank
has to be prepared to either provide any excess foreign exchange
needed or alternatively, accumulate all excess foreign exchange
inflows.
If the central bank is not prepared to provide or absorb any
imbalances, then the exchange rate will be determined by market
forces, rising and falling to bring desired inflows and outflows into
approximate balance. In order to gain an understanding of how
4

Exchange Rates are usually defined in
terms of a currency’s equivalence to one
U.S. dollar.
Nominal Exchange Rate
The price of one currency in terms of
another.
Real Exchange Rate
The price of one country’s products in
relation to that of another.
that works, we need to first understand the difference between the
nominal and real exchange rate.
NOMINAL AND REAL EXCHANGE RATES
One of the factors that differentiates cross border transactions from
those within a country is that cross border economic activity
usually requires a change of currency. In order for most consumers
in the world to drive a Japanese car, the person or firm responsible
for the importation has to get their hands on the foreign exchange
with which to pay for the car. The Japanese seller is unlikely to
accept Angolan Kwanzas, Icelandic Kronas, or Philippine Pesos in
exchange for the car. And even if he does, he will promptly offer it
up in exchange for a currency that is more useful to him, such as
his own country’s Yen or an international currency such as the
Euro. Either way, someone involved in the trade has to conduct a
currency transaction.
For this reason, changes in the exchange rate are of critical
importance to many economies, and it is therefore important to Commented [DK2]: Reason why it’s important still not
understand the factors that influence such changes. Before we can clear. Connect the dots.
do so, though, we need to understand the difference between the
nominal exchange rate and the real exchange rate.
The nominal exchange rate is the price of one currency in terms of
another. It therefore provides a relative price at which to exchange
money in one currency into its equivalent amount in another. It is
conventional to define exchange rates as the cost in domestic
currency of buying one United States dollar. So, for example, the
exchange rate between Chilean Pesos and the U.S. dollar is
expressed as 480 Pesos to the dollar.
When the domestic currency depreciates, it loses value relative to
other currencies. It will therefore require more of the now
depreciated domestic currency to purchase a U.S. dollar. For
example, a depreciation of the Chilean Peso would have occurred if,
instead an exchange rate of 480 Pesos to the dollar, it required 500
Pesos to buy a U.S. dollar.
The real exchange rate measures the price of one country’s
products in relation to another – not how many Malaysian Ringgits
are required to purchase a U.S. dollar, but how many Malaysian
Tiger beers it would take to buy a bottle of American Budweiser.
Suppose a Budweiser in the U.S. sells for US$2; the exchange rate for
Malaysian Ringgits is RM3 to the dollar; and a bottle of Tiger beer in
Malaysia is worth RM6. Then we can work out that, since the cost of
the Budweiser in Ringgits is RM6 and one bottle of Tiger can fetch
RM6, then one Tiger is the equivalent of one Budweiser.
5

Real Exchange Rate: How much
Malaysian beer does it take to buy an
American beer?
If the American price of a Budweiser rises, or the number of
Ringgits per dollar rises (a nominal depreciation), or the price of a
Tiger in Malaysia falls, it will then require more Tigers to be the
equivalent of a Budweiser. The Tiger will have depreciated in value.
That is, relative to Budweisers, Tigers have become cheaper.
Similarly, there will have been an appreciation, that is, Tigers will
be more valuable in terms of Budweisers, if any of the following
happens: the price of a Budweiser falls, the exchange rate falls, or
the Ringgit price of a Tiger rises.
While we have used a single product to illustrate the concept of the
real exchange rate – the amount of Tiger beer required to buy a
Budweiser – the concept applies to the broad range of products
produced by one country in relation to the equally broad range (but
likely consisting of different products) produced by the other
country. Thus, a country experiencing a real depreciation will
observe its own products are generally becoming cheaper relative
those of its trading partners.
A Real Exchange Rate Formula
The idea behind the real exchange rate can be captured by a simple
formula.
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 × 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
𝑟𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 =
𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
Let’s see how this expression can help us to understand how the
real exchange rate can change. Suppose the nominal exchange rate
and the foreign country’s price level both remain unchanged, so the
numerator of the fraction shown does not change in value. If at the
same time, however, the home economy experiences rising prices,
then the domestic price level in the denominator will take on a
larger value. With a larger denominator, the entire ratio will be
smaller, so the real exchange rate will have a lower value,
reflecting that it will now require fewer domestic goods to procure
a given amount of foreign goods. There will have been an
appreciation of the domestic currency in real terms.
Alternatively if the domestic price level remains unchanged but
either the nominal exchange rate or the foreign price level in the
numerator rises, then the real exchange rate will have risen – a real
depreciation of the currency. It will then require more domestic
output to buy a given amount of foreign products.
Note that if the nominal rate is stuck at any particular value, then
figuring out what is happening to the real exchange rate is simply a
matter of comparing the changes in the two price levels. If, for
example, both countries are experiencing inflation but the local
6
inflation rate is higher than the foreign one, then the denominator
is expanding faster than the numerator so the real exchange rate is
falling – a real appreciation.

Real Exchange Rates and Trade

Like any consumption choice, a person’s choice between
consuming a domestically produced product and one that is
produced abroad will be influenced by a large number of
considerations, including tastes, culture, and the level of the
consumer’s income. And as we have already seen in our discussion
of demand, in addition to those considerations, the price of any
particular good or service relative to others will also be a key
determinant. When such a comparison is made between a
domestically produced product and one that originates in another
country, it is the real exchange rate, not the nominal rate, that
reflects the relative price of the two products.

To see the role of the real exchange rate in practice, consider a

typical Kuala Lumpur resident in Malaysia as he contemplates his
beer purchasing decision. In choosing between the local Tiger
brand and an imported Budweiser from the United States, his
preference for the sweeter taste in the imported lager could be a
consideration, as perhaps will his cultural affinity for the local
brew. In addition, the relative price of the two products when
measured in local currency, the real exchange rate that is, will also
be a factor.

Suppose our Kuala Lumpu beer consumer currently splits his

purchases between the two brands. Now suppose there is a change
in the relative price of the two products. While the U.S. dollar price
of a Budweiser rises by 3 percent, say, the Malaysian Ringgit price of
a Tiger may have risen by 10 percent. Meanwhile, the nominal
exchange rate remains unchanged. The combined effect of all the
above will be to make Tigers more expensive relative to
Budsweisers or, alternatively expressed, Budweisers relatively
cheaper compared to Tigers. In other words, there has been a real
appreciation of the Malaysian currency.

The typical consumer is likely to respond to this relative price

change by reducing his consumption of the now relatively more
expensive Tiger and substituting for it the now relatively cheaper
Budweiser. Since many consumers will do the same, imports of
Budweiser into Malaysia will rise. And since consumers will be
carrying out a similar comparison over a range of products, we
conclude that a real appreciation of the Ringgit stimuolates a rise in
imports. Correspondingly, a real depreciation of the local currency,
which raises the relative cost of imports, will lead to a decrease in
imports.

7
Out story is not done, yet. Consumers outside of Malaysia will also
notice the change in relative costs. Beer drinkers in Bangladesh, for
example, are also likely to respond to the higher cost of a Tiger
relative to a Budweiser by shifting consumption from the Malaysian
brand to the American one. Since Tiger is not brewed locally in
Bangladesh, the reduced consumption of the brand in favour of
Budweiser will represent a reduction in export demand for the
Malaysian-produced product. So the real appreciation of the
Malaysian currency also promotes a fall in Malaysian exports.

These changes in imports and exports that result from consumption

decisions are reinforced by decisions on the production side of the
economy as well. After a real appreciation, a Malaysian brewer will
get more revenue for beer sold at home compared to beer exported
to, say, the United States. He will therefore want to shift his
production capacity from producing for the export market towards
producing for the local market. As he does so, exports will fall.
Similarly, American brewers will now be more inclined to send
product to Malaysia where beer is fetching a relative higher price
than at home. So Malaysian imports rise.

The comparison of the cost of beer in the two countries is only

illustrative since the influence of the real exchange rate on exports
and imports does not depend on a comparison of a particular
product such as beer or even of products similar to each other. The
real exchange rate reflects the cost of the broad collection of goods
and services produced in an economy relative those produced in
other countries. And as those relative costs change, consumers and
producers at home and abroad will shift their consumption and
sales pattern between the two economies even if the goods and
services produced by the two economies are not similar.

To summarize, the real value of the currency, as distinct from the

nominal value, includes consideration of relative price levels in
order to arrive at the relative cost of foreign goods vis-à-vis
domestic goods. And changes in that relative cost influences the
amounts of imports and exports of a country. In particular, a real
appreciation reduces net exports (that is, reduces exports while
stimulating imports) while a real depreciation will have the
opposite effect, increasing exports and reducing imports. The real
exchange rate signals consumers and producers about how to
allocate their purchases and sales between the domestic economy
and the rest of the world.

THE FOREIGN EXCHANGE MARKET

We have established that the real exchange rate is important
because it affects a country’s levels of imports and exports. The real

8

Figure 2: The Market for Foreign
Exchange
exchange rate also affects the volumes of other international
transactions. The real exchange rate is an especially important
variable in more open economies – those in which international
transactions are large relative to the size of the domestic economy.
So how the real exchange rate is determined is important.
The exchange rate is just a price – the price of consuming foreign
goods. Prices are usually determined in markets, and in countries
with flexible, market-determined exchange rate regimes, the
exchange rate is determined in the market for foreign exchange.2
The foreign exchange market consists of buyers and sellers of
currency all over the world trading currencies through a wide
variety of institutions and media. Trading is done through
commercial banks, central banks, cambios, online brokers and in
some countries, informal street traders. Most of the currency
trading in the world, however, is done through approximately a
hundred large banks.
Only a handful of currencies are widely traded across dispersed
foreign exchange markets worldwide – United States dollar,
European euro, British pound, and Japanese yen. For most
currencies, the vast majority of the trading in them is localized,
taking place in the banks and cambios located in the home country
of the currency. If a merchant in Myanmar wanted to import wine
from France, he would not have much luck trying to unload his
kyat with a Parisian bank in order to get the Euros he needs to pay
for transaction. That currency transaction would most likely take
place with a bank in Myanmar.
To model the foreign exchange market, we measure on the
horizontal axis in the market diagram shown in Figure 2 the
amount of foreign currency that is bought or sold during some time
period. On the vertical axis, we show various possible values of the
real exchange rate.
The vertical line labeled “nKi”, standing for net capital inflows,
represents the net inflows from the capital account of the balance
of payments. It is the the difference between, on one side, inflows of
foreign exchange from inward direct investment and purchases of
domestic securities by foreigners and, on the other, outflows for
outward direct investment and purchases of foreign securities by
locals. If you are a resident of Papua New Guinea, for example, it is
the difference between the proceeds from selling your small farm
to an Australian investor and the amount you decide to invest in
Japanese shares, aggregated over all such transactions during a
given period of time.
9

Figure 3: Determining the equilibrium
real exchange rate
“nKI” – the net supply of foreign exchange from asset transactions –
is vertical to reflect that cross-border purchases and sales of assets,
whether for fixed capital or securities, is not much affected by the
level of the exchange rate. International investors would certainly
take into account their expectation about the likely movement of the
exchange rate over time, since that will affect their return on the
investment when that return is expressed in their local currency.
With respect to different levels, however, net capital inflows will be
the same and is therefore represented by a vertical line.
The line labeled “M-X” represents the foreign exchange flows
derive from the current account of the balance of payments
(ignoring income transfers for simplicity). It is the trade deficit – the
difference between the outflows of foreign exchange for the
purchase of imports and the inflows from the proceeds of exports.
So if you’re that resident in Papua New Guinea, “M-X” represents
the difference the cost of purchasing that German BMW and the
proceeds of the exports of palm oil from your small farm. It is the
therefore the net demand for foreign exchange for the purposes of
trade.
That trade deficit will be affected by the level of the real exchange
rate. A rise in the exchange rate (a currency depreciation) makes
imports relatively more expensive in local currency and thereby
reduces the demand for imports, and therefore reduces the
outflows of foreign exchange. At the same time, the exchange rate
rise makes domestic products relatively cheaper to foreigners,
resulting in a greater volume of goods and services being exported,
raising export proceeds. The currency depreciation therefore
reduces the net demand for foreign exchange for trade purposes.
For this reason, on the diagram of the foreign exchange market in
Figure 2, we show the “M-X” line as downward-sloping.
If the current level of the real exchange happens to be such that the
net inflows of foreign exchange from inward direct investment and
portfolio investment exceed the outflows to finance the trade
deficit, then foreign exchange traders, rather than accumulate
unsold foreign exchange, will lower the nominal exchange rate so
as to attract purchasers of foreign exchange. This is illustrated by
exchange rate E1 in Figure 3 at which the quantity of foreign
exchange supplied from capital flows, “b”, exceeds the quantity
demanded to finance the trade deficit, “a”. This is no different from
when a vender in a produce market reduces her price in order to
stimulate greater sales. The reduction in the nominal rate would
have to be sufficient to compensate for any changes in the two
countries’ price levels to ensure that the real exchange rate falls.
(Review the real exchange rate formula above if the previous
sentence is not sufficiently clear.)
10

Figure 4: An Increase in Imports
Conversely, if the current real exchange rate is such that net trade
outflows exceed net capital inflows inflows, then forex traders will
want to raise their nominal exchange rate rather than wait until
their foreign exchange float runs out leaving them with no more
foreign exchange to sell. Exchange rate E2 in Figure 3 represents
this possibility where the quantity supplied from the capital
account is only “c” while the quantity needed for trade is the larger
amount “d”. Raising the nominal rate, other things remaining
unchanged, will raise the real rate.
Since excess supply of foreign exchange induces the real exchange
rate to fall and excess demand induces it to rise, the real exchange
rate will generally drift towards the market-clearing equilibrium –
exchange rate E0 in Figure 3 – at which inflows and outflows are
equal.
Disturbances to the Market
A country’s foreign exchange transactions are affected by much
else besides the exchange rate. As incomes in a country rise or fall,
for example, purchases of consumer items will naturally rise or fall
along with it. Since a typical household’s consumption will include
some foreign goods, and even domestically produced goods and
services will use some inputs procured from abroad, any change in
the level of income will therefore induce a corresponding change in
the amount of imports. In this way, rising income levels in a
country will stimulate, through increased consumption of imports,
increased demand for foreign exchange. This is represented on the
market diagram as an outward (or rightward) shift of the M-X
curve, as shown in Figure 4.
In a similar manner, rising income abroad, in the economies of a
country’s trading partners, will induce higher consumption there,
which consumption will include some commodities and inputs that
are produced in your economy, raising exports and thereby
increasing inflows of foreign exchange. In this way, higher incomes
abroad result in an inward (or leftward) shift of the M-X curve.
One way in which the rapidly rising incomes in China is being spent
is on holidays abroad. So nearby countries will experience an
increase in visits by Chinese tourists, boosting the inflows of foreign
exchange in the countries being visited. This situation, applicable to
the countries receiving Chinese tourists, such as the Pacific islands,
would be shown as a leftward shift of their M-X curve. The
additional inflows will create an excess supply that will propel the
real exchange rate downwards in order to encourage potential
foreign exchange users to purchase the newly earned foreign
exchange.
11

Figure 5: An fall in Domestic Interest
Rates
Interest rates also influence the demand for and supply of
currencies. The rate of interest in a country indicates the returns to
be had from holding financial investments in that country, such as
lending money to the government. If domestic interest rates were to
fall, say, the return on the loans may not compensate some lenders
for the perceived risk of lending to a perhaps unreliable
government. These investors would therefore want to shift their
financial investments to other countries whose interest rates may
not have fallen and who therefore now offer a comparatively better
prospect. As financial capital moves out of the country, net capital
inflows would be lower. As a consequence, then, of lower domestic
interest rates, net capital inflows will fall and consequently the
exchange rate will rise, reflecting a depreciation of the currency, as
illustrated in Figure 5.
Anything, therefore, that causes a change in the demand for or
supply of foreign exchange will have a consequence for the level of
the real exchange rate. A bumper harvest of a major export crop
will boost foreign exchange earnings – an inward shift of the trade
deficit curve – and cause the exchange rate to fall. An increase in
external borrowing by the government will also have the same
effect, as the government has to sell the borrowed foreign exchange
in order meet its domestic spending obligations in local currency.
In a non-oil producing country, a rise in the world oil price will
raise the bill for importing oil and so increase the demand for
foreign exchange, driving up the exchange rate.
The real exchange rate moves up and down to equate inflows and
outflows of foreign exchange. Those flows include those for the
purchases and sales of assets as well as the imports and exports of
goods and services.
PURCHASING POWER PARITY
The demand and supply model of the foreign exchange market,
which is based on foreign exchange earnings and outflows, helps us
to understand how the real exchange rate responds to changes in
inflows and outflows of foreign exchange in the short run. But what
about the factors that determine those flows themselves? If we have
that information, we will understand what factors drive the real
exchange over the long run.
This discussion will also provide an explanation for the long run
secular depreciation of the nominal exchange rate observed in
many developing countries. To procure one U.S. dollar took only
eight Jamaican dollars in 1990 but by 2014 required more than 14
times as much Jamaican currency to buy the same dollar? It is
certainly not because the real exchange rate has changed by that
12

Arbitrage
The exploitation of price differences
between difference markets in the
same commodity.
Law of One Price
A commodity can have only one
price. Price variation in markets
between which there is trade will be
arbitraged away.
multiple over the period. Indeed, the real exchange has hardly
changed from the value it had nearly a quarter century earlier. To
explain movements in the nominal exchange rate, even when there
is no corresponding change in the real rate, we turn to the theory of
purchasing power parity.
Arbitrage and the Law of One Price
Arbitrage is the profitable exploitation of different prices for the
same commodity in different markets. Fruit vendors do this when
they purchase fruit cheaply in the countryside and then bring it to
the city where it can be sold at a higher price. Currency traders also
exploit opportunities for arbitrage. If the pound is selling for $1.50
in New York and $1.48 in London, an arbitrageur can profit by
simultaneously purchasing pounds in London and selling them in
New York. Arbitraging mangoes is no different from doing so with
currencies.
Because they are always persons willing to take advantage of
arbitrage opportunities, such opportunities tend not persist for
long. The arbitrageurs increase the demand for the commodity in
the market where the price is lower, pushing the price up, and
increase the supply in the market in which the price is higher,
driving the price down. These forces should continue until the two
prices are unified, or at least until the difference between them is
sufficiently small such that the cost of transportation between the
markets will absorb any profit remaining to be had from
arbitraging further.
Arbitraging underlies the law of one price, which states that a
commodity cannot have different prices persisting in different
markets if trade can take place between those two markets. In
practice, of course, a price difference can persist as long as the
difference is less than the cost of transportation between the two
markets. Price differences for the same commodity may also persist
if the difference reflects conditions that differentiate the two
markets, such the convenience, security, or pleasure of shopping in
one place versus another. But arbitrage will always eliminate any
price differences that are greater than those considerations can
justify.
The law of one price operates only weakly between different
countries. Governments erect artificial barriers to trading
commodities, barriers such as import tariffs and quality
restrictions. Additionally, it is inconvenient and costly to transport
some types of commodities, such as carbonated sodas, across great
distances. And many products are not tradable at all, such as
housing and haircuts. For these reasons, the forces of arbitrage
exhibit only a weak influence across international borders. And so,
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 for particular commodities, large price differences can and do
persist between countries.

The Real Exchange Rate in the Long Run

However weak, international commodity arbitrage does exert some
influence on price equalization in different countries. This
influence will be evident, not so much for individual products, but
more so for the general price level and only over the long run. And
it operates through changes in the nominal exchange rate.

If, at the current level of the nominal exchange rate, goods are
generally cheaper abroad than they are in the home country, an
arbitrage opportunity will be present. Even if inflows and outflows
of foreign exchange are in balance to begin with, before long,
consumers will seek to take advantage of cheaper imported goods.
The growing demand for those imports will as an outflow of foreign
exchange. At the same time, the relative costliness of domestic
production will be recognized by consumers abroad as well who
will therefore diminish their purchases of our exports,
simultaneously reducing inflows of foreign exchange on the trade
account. Both of these developments are illustrated by the outward
shift of the M-X curve in Figure 6.

In this way, whenever there is a substantial divergence between the

Figure 6: What happens when your
country’s trading partner has a lower cost
of goods?
cost of goods at home and abroad, trade flows and the
corresponding demand for and supply of foreign exchange will
drive the real exchange rate towards the one that equates the
purchasing power of a given amount of money in the two currency
areas, that is, towards the exchange rate that achieves purchasing
power parity or PPP.

Suppose a shopping cart’s worth of grocery items costs 300 Shekels

in Tel Aviv while the same grocery list can be filled in New York for
PPP Exch. Rate =
𝑙𝑜𝑐𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 $75. The comparison implies that the exchange rate that would
𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 equate the purchasing power of 300 Shekels in both countries is 4
300 𝑆ℎ𝑒𝑘𝑒𝑙𝑠 Shekels to US$1. That is the PPP exchange rate.
=
𝑈𝑆$75
But suppose further that the current exchange rate is actually 3.5
= 4
Shekels to US$1. The PPP theory suggests that, as consumers seek to
take advantage of the generally lower prices of American goods,
Israeli imports will rise and over time this will depreciate the
Israeli Shekel towards 4 Shekels to US$1.

The Nominal Exchange Rate in the Long Run

For pairs of countries that both have low inflation rates, small
changes in their rates of inflation, and therefore correspondingly
small changes in the PPP exchange rate, do not seem to have
discernible effects on the nominal exchange rate between their

14
 currencies, especially in the short run. But for countries that allow
their inflation rates to depart substantially from that of their
trading partners, the foreign exchange market does not tolerate
significant departures from PPP for very long. Before long, the
difference between the two countries’ inflation rates is likely to
result in a compensating movement in the nominal exchange rate
in order to restore purchasing power parity.

Since the PPP exchange rate is the ratio of the cost of goods in the
local market to that in the country of the other currency, then the
80 PPP rate should, on average and in the long run, rise at a rate equal
Nominal
Exchange to the difference between the inflation rates at home and in the
Rate other country. A large inflation differential will produce a rapidly
40
rising PPP exchange rate and therefore an equally rapidly rising
actual exchange rate.
20
PPP
Exchange As an example of purchasing power parity in action, Figure 7 shows
Rate the growth of the nominal exchange between Jamaican dollars and
10
the U.S. dollar from 1990 to 2012 (the amber line) as it moved from
eight Jamaican dollars for a U.S. dollar all the way up to 91. The
5 darker-coloured line beneath shows what the exchange rate would
1990 2000 2010
have been if the difference between the American and Jamaican
Figure 7: Nominal and PPP Exchange inflation rates (that is, PPP) had been the only influence on it. Since
Rates, Jamaican Dollar to U.S. Dollar the two lines are closely aligned, it shows that the nominal
exchange rate has not departed by much from what PPP alone
would have dictated. We conclude that purchasing power parity
has been the primary factor behind the substantial increase in the
nominal exchange rate between Jamaican and U.S. currency over
the last quarter century.

EXCHANGE RATE REGIMES

Countries differ in the rules and policies that govern the behaviour
of the foreign exchange market. The differences have to do with the
extent to which market forces are allowed to influence the
exchange rate. In order of market influence, there are flexible or
effectively exchange rates, intermediate regimes, pegged exchange
rates, and currency unions.

Flexible Exchange Rates

Flexible Exchange Rate
An exchange rate determined by
market forces
A flexible exchange rate regime is one in which the exchange rate is
determined by market forces. Each commercial bank, cambio and
trader adjusts its buying and selling rate for foreign currency to
reflect the relative volumes of purchases and sales occurring on a
given day.

From the perspective of the broader economy, this flexibility in the

exchange rate ensures that inflows and outflows of foreign

15
exchange are constantly being brought into alignment. Excess
demand stimulates a depreciation which diminishes the excess
demand; Excess supply results in an appreciation which similarly
reduces the excess. In this way, the market ensures that inflows and
outflows of foreign exchange are kept closely aligned.

As a result of this alignment, the central bank never needs to get

involved in the market. It can choose to do so whenever it feels that
it would like to increase its own reserves of foreign exchange, in
which case it will purchase foreign exchange, or if it decides to
reduce its holdings, in which case it would sell. But there would be
no obligation for the central bank to enter the market if it were
satisfied with its current level of international reserves.

Some flexible exchange regimes are “lightly managed,” meaning

that the central bank does reserve, and occasionally exercises its
right, to intervene in the market to smooth out what it deems to be
unusual volatility in the exchange rate. This may be due to
speculative activity on the part of foreign exchange market traders
or simply due to the effect of large, single transactions in markets
that usually have small volumes. Such interventions, however, are
not guided by the pursuit of a particular view of the appropriate
level of the exchange rate.

Flexible exchange rate regimes have the advantage of providing a

quick and automatic response to external shocks that affect a
country. Suppose demand for a country’s exports were to decline.
In the absence of an automatic response from the exchange rate,
the country’s production would have to contract, likely resulting in
unemployment and economic hardship. With a market-determined
exchange rate, however, the reduction in exports will automatically
instigate a currency depreciation, which in turn will stimulate
higher demand for domestic goods by both foreigners and locals,
automatically mitigating the fall off in exports. Flexible exchange
rates act as a “shock absorber” for the domestic economy in the
presence of shocks from the global economy.

Most of the large, developed countries have flexible regimes. The

United States dollar, The Japanese yen, and the Australian dollar
are all so-called “floating” currencies whose exchange rates move
up and down on a daily basis. Many developing and emerging
countries also have flexible exchange rates for their currencies.
Examples include the Georgia lari, the Papua New Guinean kina
and the Zambia kwacha.

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Fixed Exchange Rate
An exchange rate which is fixed or
“pegged” to the value of another
currency.
Figure 8: A pegged exchange rate that
requires the central bank to supply
foreign exchange to the market.
Fixed Exchange Rates
An alternative to having market forces adjust the exchange rate
every time there is a need for such is to fix, or “peg”, the exchange
rate to another currency. Nepal’s rupee has been pegged at a value
of 1.6 rupees to the United States dollar since 1993.
Under a fixed exchange rate regime, the central bank has to be
willing to trade foreign exchange at that fixed rate. It is the central
bank’s willingness and readiness to do so that actually fixes the
rate. With the central bank standing by ready to trade, no buyer
will pay anyone else a higher rate and no seller will accept a lower
rate.
Since the central bank is obligated to trade foreign exchange at the
pegged rate, any discrepancy between the amount the market
wants to sell and what it would like to buy has to be made up by the
central bank. At any point, therefore, unless the pegged rate just
happens to be one that naturally equates inflows and outflows, the
central bank will find its foreign exchange reserves either
accumulating or depleting. Figure 8 shows an exchange rate peg at
which the quantity of foreign exchange required exceeds that
coming in. The central bank would have to deplete its reserves by
an amount equal to c-d each period to make up the difference.
Neither situation, accumulation or depletion, can proceed
indefinitely, so countries with fixed exchange rates occasionally
have to adjust the peg to a different level in order to bring inflows
and outflows into closer alignment.
Fixed exchange rate regimes that can be maintained at the same
peg over long periods, such as Panama’s balboa (unchanged since
1904) or Swaziland’s lilangeni (since 1974), have the advantage of
minimizing exchange rate uncertainty that can be detrimental to
investment planning in open economies. Thus, countries with
successful pegged regimes tend to have higher rates of investment.
While much less popular than it used to be, fixed exchange rate
regimes are sill the norm in many parts of the world. Hong Kong’s
dollar, Lesotho’s loti, Latvia’s lats, and Saudi Arabia’s riyal are all
pegged to one or another of the world’s major currencies.
Intermediate Regimes
In between the extremes of market determined and fixed exchange
rates lies a continuum of exchange rate policy stances that can be
adopted by a country’s monetary authorities. These regimes look
either like flexible regimes with active intervention or like pegs that
may be adjusted more or less frequently.
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Currency Union
Several independent countries
sharing a common currency.
Some countries employ largely market determined exchange rates
but with the monetary authorities having strong views on the
appropriate level of the real exchange rate to maintain a smoothly
functioning economy. In such cases, they are prepared to intervene
strongly in the market in order to push the exchange rate towards
its desired level. Such “dirty” floats depend on the skill of the
technocrats in identifying the appropriate exchange rate and to
know when to abandon it in the presence of sufficiently powerful
market forces. The Argentinian peso and Russian rouble fall in this
category.
Some countries allow the exchange rate to float as long as it
remains within a range predetermined by the central bank.
Whenever the rate threatens either of the boundaries, they will
intervene in the appropriate direction to move the rate away from
the boundary.
Finally, crawling or adjustable pegs may operate like fixed pegs but
with the understanding that the monetary authorities will changed
the pegged rate at regular or irregular intervals in response to
foreign exchange inflows and outflows. In some cases, the
adjustments are predetermined both as to timing and rates.
Botswana’s pula and Costa Rica’s colón are classified as adjustable
pegs.
These hybrid regimes – neither fully floating nor permanently fixed
– are attempts to balance the advantages and disadvantages of both
floating and fixed regimes at the same time. Managed floats and
adjustable pegs bring some stability and therefore predictability to
the exchange rate but at the same time allow the rate to change if a
fundamental misalignment emerges between local and foreign
price levels.
Currency Unions
A few countries don’t bother with managing an exchange rate at all
because they have decided not to have their own independent
currencies. Groups of countries may choose to establish a common
currency for all of them together. The countries of the European
Union all use the Euro; those islands that belong to the Eastern
Caribbean Currency Union share the Eastern Caribbean dollar.
Several west and central African states jointly use the CFA Franc.
While formal currency unions, such as those above, describe
groups of countries that come together as equals to share a
currency created for the purpose, included in this category are also
countries that simply choose to adopt the currency of a larger
neighbouring state. Kiribati uses the Australian dollar; Namibia,
18
Lesotho, and Swaziland uses the South African rand; and Ecuador
and El Salvador use the United States dollar.

Countries such as these without independent currencies do not face

the question of how to manage their exchange rates. Being part of a
currency union is equivalent to having a permanently fixed
exchange rate vis-à-vis the other countries with which a currency is
shared.

CONCLUSION
Developments in the rest of the world are often as impactful on an
economy as events that originate locally. A sudden change in a
commodity price (oil, copper, sugar, wheat) on world markets, the
local investment of a large global business, or a cessation of the
inflows of remittances from relatives abroad, can have dramatic
consequences for an economy. Every national economy has
linkages with the rest of the world through the international flow of
goods, capital, and income.

The balance of payments accounts is a way to keep of track of the

flow of payments that derive from these myriad interconnections.
Since most countries do not have the luxury of making
international payments in their domestic currency, then ultimately,
inflows and outflows of foreign exchange have to move towards
equality, regardless of the exchange regime.

The foreign exchange regime determines the rules governing flows

of foreign exchange and the way in which the exchange rate adjusts
to changes in the flows. Above, we looked at a variety of regimes,
ranging from not having an independent currency at all to a freely
floating exchange rate.

Which is the right kind of arrangement varies depending on the

particular circumstances of each country – the size of the economy,
its degree of engagement with the global economy, and its own
institutional capacities. But for all countries, international
developments and the regime through which it affects the local
economy have important effects.

1
The IMF splits what the rest of the world calls the capital account
into two parts: the financial account and the capital account, with
most of the transactions falling into the financial account.
2
In some countries, the nominal exchange rate is “pegged” to the
value of another currency and is not allowed to vary in order to
allow for easy adjustment of the real exchange rate.

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