• Formula: The nominal exchange rate is typically expressed as the amount of domestic currency per unit of foreign currency. For example, if 1 USD is equivalent to 75 INR, the nominal exchange rate is 75 INR/USD.
• Determination: Nominal exchange rates are influenced by factors such as interest rates, political stability, economic performance, and market speculation.
• Types:
  • Floating Exchange Rates: These rates are determined by the free market forces of supply and demand relative to other currencies.
  • Fixed Exchange Rates: Here, the currency's value is pegged to another major currency or a basket of currencies.

Example: If the European Central Bank sets the euro's exchange rate at 1.20 USD, it means 1 euro can be exchanged for 1.20 US dollars nominally.

• Formula: $$Real\ Exchange\ Rate = Nominal\ Exchange\ Rate \times \frac{Domestic\ Price\ Level}{Foreign\ Price\ Level}$$
• Interpretation: A real exchange rate greater than one indicates that domestic goods are more expensive than foreign goods, potentially reducing exports. Conversely, a real exchange rate less than one suggests that domestic goods are cheaper, potentially boosting exports.
• Significance: The real exchange rate is crucial for assessing competitiveness, cost of living comparisons, and making informed economic policy decisions.

Example: Suppose the nominal exchange rate between the US and Japan is 110 JPY/USD. If the price level in the US is 200 and in Japan is 250, the real exchange rate is:

This indicates that US goods are relatively cheaper compared to Japanese goods.

• Absolute PPP: Suggests that the nominal exchange rate equals the ratio of the countries' price levels.
• Relative PPP: Focuses on the rate of change in prices, asserting that the exchange rate will adjust to offset differences in inflation rates between two countries.

Example: If the inflation rate in Country A is higher than in Country B, the real exchange rate should depreciate in Country A relative to Country B to maintain PPP.

• Exports and Imports: A depreciation in the domestic currency makes exports cheaper and imports more expensive, potentially improving the trade balance.
• Inflation: Imported goods become more expensive with a depreciated currency, contributing to inflationary pressures.
• Investment: Exchange rate stability is crucial for attracting foreign investment, as volatility increases risk.

• Interest Rates: Higher interest rates offer lenders a better return relative to other countries, attracting foreign capital and causing the currency to appreciate.
• Economic Indicators: Strong economic performance, reflected in GDP growth and low unemployment, can lead to currency appreciation.
• Political Stability: Countries with stable governments are more attractive to foreign investors, supporting stronger currencies.
• Market Speculation: Traders' perceptions and expectations about future economic conditions can lead to significant short-term exchange rate movements.

• Consumer Price Index (CPI): Often used as a measure of the overall price level in each country.
• Basket of Goods: Selecting a representative basket of goods ensures that the real exchange rate reflects changes in purchasing power accurately.
• Calculation Steps:
  1. Determine the nominal exchange rate (e.g., USD to EUR).
  2. Obtain the domestic and foreign price levels (e.g., CPI of the US and the EU).
  3. Apply the real exchange rate formula to adjust for price differences.

• Trade Policy: Policymakers analyze real exchange rates to gauge export competitiveness and make informed decisions on trade agreements.
• Investment Decisions: Investors consider exchange rate movements to assess the risk and return of international investments.
• Economic Forecasting: Economists use exchange rate data to predict future economic conditions and advise on monetary policy.

• Balassa-Samuelson Effect: Suggests that countries with higher productivity growth in the tradable goods sector will experience real exchange rate appreciation.
• Trade Balance Adjustments: Changes in the real exchange rate can lead to adjustments in the trade balance through alterations in the volume of exports and imports.

Formula: $$Real\ Exchange\ Rate = \frac{Nominal\ Exchange\ Rate \times P_{domestic}}{P_{foreign}}$$

• Short-Term Impact: Initially, the value of imports increases due to the higher cost of foreign goods, worsening the trade balance.
• Long-Term Adjustment: Over time, exporters benefit from the weaker currency, leading to increased export volumes and improved trade balance.

Graphical Representation: The trade balance initially dips and then rises, forming a shape resembling the letter "J."

• Full Pass-Through: Indicates that the entirety of the exchange rate change is reflected in domestic prices.
• Partial Pass-Through: Suggests that only a portion of the exchange rate change influences domestic prices.
• Factors Affecting Pass-Through:
  • Market Structure: Competitive markets may lead to higher pass-through than monopolistic markets.
  • Pricing Strategies: Firms’ decisions on pricing can moderate or amplify pass-through effects.

Example: If the domestic currency depreciates by 10%, and the cost of imported goods rises by 8%, the pass-through rate is 80%.

• Determination: Calculated using economic models that incorporate various macroeconomic indicators.
• Usage: BEER serves as a benchmark to assess whether a currency is overvalued or undervalued.
• Policy Implications: Helps policymakers in implementing measures to achieve exchange rate stability.

Formula: The BEER can be modeled as: $$BEER = \alpha + \beta_1(Trade\ Balance) + \beta_2(Net\ Foreign\ Assets) + \beta_3(Productivity) + \dots$$ where $\alpha$ and $\beta$'s are coefficients derived from regression analysis.

• Price Stickiness: Prices do not adjust instantly to changes in supply and demand, causing short-term exchange rate fluctuations.
• Implications for Real Exchange Rates: Sticky prices can lead to deviations from the PPP and affect the real exchange rate path.

Example: After a currency depreciation, imported goods may not immediately increase in price due to contracts, leading to short-term real exchange rate effects.

• Floating Exchange Rate: Determined by the market with minimal government intervention.
• Fixed Exchange Rate: Pegged to another currency or basket, requiring active government or central bank involvement.
• Managed Float: A hybrid where the currency mostly floats but the central bank intervenes to stabilize or steer the exchange rate.

Impact on Real Exchange Rates: The choice of exchange rate regime affects the volatility and long-term trends of both nominal and real exchange rates.

• Purchasing Power Parity (PPP): Focuses on price level equilibrium.
• Interest Rate Parity (IRP): Relates exchange rates to interest rate differentials between countries.
• Monetary Models: Incorporate factors like money supply, demand, and economic output.
• Behavioral Equilibrium Exchange Rate (BEER) and Fundamental Equilibrium Exchange Rate (FEER): Emphasize fundamental economic indicators.

Example: The Monetary Approach posits that exchange rates are determined by the supply and demand for different currencies based on their respective money supplies and economic activities.

• Types of Exchange Rate Risk:
  • Transaction Risk: Uncertainty in cash flows due to exchange rate movements.
  • Translation Risk: Impact on the value of financial statements when consolidating foreign subsidiaries.
  • Economic Risk: Long-term effects of exchange rate changes on a company's market value.
• Hedging Strategies:
  • Forward Contracts: Agreements to exchange currencies at a predetermined rate on a future date.
  • Options: Contracts that grant the right, but not the obligation, to exchange currencies at a specific rate.
  • Futures Contracts: Standardized contracts traded on exchanges to buy or sell currencies at a future date.

• Current Account: Includes trade balance, services, income, and current transfers. Exchange rate changes can affect the trade balance by altering export and import volumes.
• Capital and Financial Account: Records capital transfers and transactions in financial instruments. A strong currency may attract foreign investment, impacting the financial account.
• Overall Balance: Persistent imbalances can lead to exchange rate adjustments either through market mechanisms or policy interventions.

• Formula: $$REER = E * \left(\frac{P_d}{P_f}\right) \times w$$ where \(E\) is the nominal exchange rate, \(P_d\) and \(P_f\) are domestic and foreign price levels, and \(w\) represents trade weights.
• Significance: REER provides a comprehensive view of a country's international competitiveness by accounting for multiple trading partners and price level differences.

Interpretation: An increasing REER indicates that a country's goods are becoming more expensive relative to its trading partners, potentially reducing competitiveness.

• Fixed Exchange Rate Regimes: Require active intervention in foreign exchange markets to maintain the pegged rate, often necessitating adjustments in monetary policy to sustain the target.
• Inflation Targeting: Some central banks focus on controlling inflation, allowing exchange rates to fluctuate based on market conditions.
• Impact on Real Exchange Rates: Exchange rate targeting can influence real exchange rates through adjustments in price levels and economic output.

• Examples: The Eurozone is a prominent example where member countries share the euro as their official currency.
• Benefits: Reduce transaction costs, eliminate exchange rate risk among members, and promote economic integration.
• Challenges: Loss of individual monetary policy control, requiring member states to adhere to common fiscal and economic policies.

Implications for Real Exchange Rates: While nominal exchange rates are fixed within the union, real exchange rates can still fluctuate based on domestic price levels and productivity differences.

• Nominal exchange rates represent the direct value of currencies without adjusting for price levels.
• Real exchange rates factor in price level differences, offering a measure of purchasing power and competitiveness.
• Understanding both rates is essential for analyzing trade dynamics, investment decisions, and economic policies.
• Advanced concepts like PPP, the J-Curve, and REER provide deeper insights into exchange rate behaviors and impacts.