Exchange Rate Policy

International Finance @ IIT Kharagpur © G

S Hiremath
 The economics of exchange rates(1)

Revisiting some basic national income accounting…

Y = C + G + I + NX

where NX = Exports – Imports

Rearranging terms:
Y – C – G – I = NX

Remember that Private saving = Y – C – T and that Public saving = T – G ,

So,
S – I = NX
What is NX? The trade balance
What is S – I? Net foreign investment
Why must these be equal?

International Finance @ IIT Kharagpur © G

S Hiremath
 The economics of exchange rates(2)

S – I = NX

What if S – I = NX > 0 ? Trade surplus and net lending to ROW.

Why must both be true? We must have lent them something so they can buy more
than they sell us…..

What if S – I = NX < 0 ? Trade deficit and net borrowing from ROW.

Why must both be true? We must borrow so that we can buy more than we sell…

International Finance @ IIT Kharagpur © G

S Hiremath
 Real exchange rates(1)

But where does the exchange rate fit in here?

To see this, consider the real exchange rate….a measure of the purchasing power of a country’s goods relative
to other countries goods….let’s work on the US/Japan example….

Nominal exchange rate = 110 Yen/1 USD

Price of Big Mac in U.S. = $2.49; Price of Big Mac in Jap = Y262

How many Japanese Big Macs but U.S. Big Macs?

RER = (110/1)x ($2.49/Y262) = 1.04 Jap BMs/1US BMs

More generally,

RER = NER * Price of domestic goods/ Price of foreign goods

International Finance @ IIT Kharagpur © G

S Hiremath
 Real exchange rates (2)

RER = NER * Price of Domestic goods/Price of Foreign goods

What does it mean to say that RER’s have gone up? Purchasing power of a country’s
goods has gone up!

So, now let’s return to: S – I =NX. How does NX vary with the RER? Downward
slope…What about S – I ?

RER S–I

NX

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S Hiremath
NX
 Real exchange rates (3)
RER S–I

NX

What happens when S goes up? Why?

NX
What happens when I goes up? Why?
What happens when r* goes up? Why?
What happens if we ban imports? Why?

Each of these changes modify this picture by moving the lines and causing real exchange
rate changes that allow for the identity to hold…
So, real exchange rates are the prices that make sure this market equilibrate….

International Finance @ IIT Kharagpur © G

S Hiremath
 Nominal exchange rates redux (1)

• Now, let’s return to the nominal exchange rate as that’s what we observe and
what policy-makers can control….

Before we had,

RER = NER * Price of Domestic goods/ Price of Foreign goods

Turning that around,

NER = RER * Price of Foreign goods/ Price of Domestic goods

expressing that in terms of changes yields:

% change NER = % change RER + % change Foreign Prices - % change

Domestic prices or

% chg NER = % chg RER + Foreign Inflation – Domestic Inflation

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S Hiremath
 Nominal exchange rates (2)

• % chg NER = % chg RER + Foreign Inflation – Domestic Inflation

So what?
Well, now consider several possible shocks under fixed and floating regimes.

If you fix exchange rates, the left hand side is ZERO

All shocks that effect the RER must be accompanied by offsetting changes in domestic prices. All
adjustment happens through prices.

If you float exchange rates, the left hand side moves.

All shocks that effect the RER flow through to the NER. All adjustments happens through
NER movements.

International Finance @ IIT Kharagpur © G

S Hiremath
 Nominal exchange rates (3)

• % chg NER = % chg RER + Foreign Inflation – Domestic Inflation

But, if you fix exchange rates, can’t you use interest rates to counter inflation or deflation? Not, if you live in
open capital markets.
Try to live in this world with these three nice characteristics:
1) Fixed exchange rates
2) Open capital markets
3) Monetary autonomy

1) Implies no exchange rate changes;

2) Implies, with interest parity, that differences in interest rates must be accompanied by changes in
exchange rates
Together they imply that your interest rate must move with the words.
No monetary Autonomy- and for some folks that’s the whole point.

International Finance @ IIT Kharagpur © G

S Hiremath
 Nominal exchange rates (4)

• % chg NER = % chg RER + Foreign inflation – Domestic inflation

Changes one observes in the NER are either changes in the RER or arise from
monetary policy and inflation…

Higher relative inflation leads to lower nominal exchange rates as domestic inflation
goes up and RER’s are constant…

International Finance @ IIT Kharagpur © G

S Hiremath
 The choices facing governments

Fixed – HK, China Managed Float- Sing Floating – US

• What’s required for fixed?

– The backing to make good or fixed rate

• What are the benefits of fixing? Floating?

– Fixing reduces day-to-day uncertainty and can create credibility

• What are the costs of fixing ? Floating?

– Disruptions in fixed regimes are likely to be larger
– How does one adjust calmly
– Bad choices are hard to get out of

International Finance @ IIT Kharagpur © G

S Hiremath
 The consequences of those choices

• When shocks happen, something’s got to give

– Real x Rate = Nominal x Rate * Ratio of Price Levels

(just like nominal and real interest rates)

• Under fixed exchange rates, the adjustment happens domestically with price
changes

– Monetary policy is all about the exchange rate

• Under floating exchange rates, the adjustment happens through the exchange
rate

– Monetary policy is about inflation and price levels

International Finance @ IIT Kharagpur © G

S Hiremath