Lesson 5: Exchange Rates and Trade Policy
1. Understanding Exchange Rates
Exchange Rate: The price of one currency in terms of another currency. It represents how much of one currency can be exchanged for a unit of another currency.
Key concepts related to exchange rates:
- Appreciation: An increase in the value of a currency relative to another currency
- Depreciation: A decrease in the value of a currency relative to another currency
- Nominal Exchange Rate: The actual rate at which currencies are exchanged
- Real Exchange Rate: The nominal rate adjusted for inflation differences between countries
2. Exchange Rate Systems
Countries adopt different systems to manage their exchange rates:
- Floating Exchange Rate: The currency's value is determined by supply and demand in the foreign exchange market
- Fixed Exchange Rate: The government sets and maintains a specific exchange rate
- Managed Float: The exchange rate is generally market-determined, but the central bank intervenes to influence its value
- Currency Board: A very strict form of a fixed exchange rate system
- Dollarization: A country adopts another country's currency (often the US dollar) as its official currency
3. How Exchange Rates Affect Trade
Exchange rates have significant impacts on international trade:
- Exports: A weaker currency makes exports more competitive in foreign markets
- Imports: A stronger currency makes imports cheaper for domestic consumers
- Trade Balance: Exchange rates can influence a country's overall trade balance
- Investment: Exchange rates affect the attractiveness of foreign investment
Example: Impact of Currency Appreciation on Trade
Suppose the US dollar appreciates against the euro:
- US exports to the Eurozone become more expensive for European buyers
- European exports to the US become cheaper for American consumers
- US companies may find it harder to compete in European markets
- European companies may gain market share in the US
- The US trade deficit with Europe might increase
4. Exchange Rate Policy as a Trade Tool
Governments and central banks can use exchange rate policy to influence trade:
- Currency Devaluation: Deliberately lowering the value of a currency to boost exports
- Foreign Exchange Intervention: Buying or selling currency in the forex market to influence its value
- Interest Rate Adjustments: Changing interest rates to affect capital flows and currency values
- Capital Controls: Restricting the flow of capital in and out of a country to manage exchange rates
5. International Coordination and Conflicts
Exchange rate policies can lead to international tensions:
- Currency Wars: Countries competitively devaluing their currencies to gain trade advantages
- G20 and IMF Coordination: International efforts to promote stable and market-oriented exchange rates
- Trade Disputes: Accusations of currency manipulation leading to trade conflicts
- Global Imbalances: Persistent trade surpluses or deficits partly due to exchange rate policies
Interactive Exchange Rate Simulator
Use the slider to see how changes in exchange rates affect the price of exports:
Exchange Rate: 100% of base rate