Exchange Rate-Introduction

Exchange rate is the  price of one currency in terms of another currency. It is the external value of a currency which determines how many units of it can be bought with another currency,  e.g. US$1 = £0.50 means that 1 US dollar can buy 0.50 UK pound. 

The foreign exchange market is a market where currencies are bought and sold. It is not located in a single place as it is a global market that is decentralised.  It establishes the rates at which different currencies are exchanged for one another. 

Depreciation and devaluation
Depreciation of a currency occurs when the value of a currency decreases in relation to another currency due to the market forces of demand and supply. If a currency depreciates against another currency, it means that more of it will need to be exchange for each unit of another currency.  Depreciation could be caused by a decrease in demand for a currency or an increase in the supply of a currency. A decrease in demand for a currency implies that less of it is wanted or bought for paying for, say, the country’s exports. The demand for the US dollar decreased from D₁ to D₂ in Figure 1 below. The US dollar depreciates against the UK pound, as a result, from US$1  for £3 to US$1 for £2. A US$ which could buy  £3 now buys lesser amount of the UK pound (£2).  Conversely, the UK pound has appreciated against the US dollar.

Figure 1: Depreciation of the US$ caused by decrease in demand

An increase in the supply of a currency will also lead to the depreciation of the currency. When there is an increase in the supply of a currency, more of it is being sold (exchanged for a foreign currency) either to pay for imports or to save in another country with a higher interest rate. In Figure 2 below, the supply of the US dollar rose from S₁ to S₂. Consequently, the US dollar depreciated from £2.50 per dollar to £1.50 per dollar because it can now buy lesser amount of the other currency, the UK pound. The effect of depreciation is that selling to other countries (exporting) becomes cheaper because the domestic country’s currency has a relatively lower value. But buying from other countries (importing) is more expensive since the currency of the selling country is stronger.

Figure 2: Depreciation of the US$ caused by increase in supply

Devaluation is the intentional lowering of the value of a currency in terms of another currency by the government. It has the same effect as depreciation as more units of the currency are now required to purchase each unit of another currency. Therefore, export prices decrease while import prices increase.  A country can devalue its currency to encourage exportation and reduce importation; it will correct a current account deficit or lead to a current account surplus.

Appreciation and revaluation
A rise in the value of a currency in relation to another currency is known as appreciation if it is caused by the market forces (demand and supply) and revaluation if it is deliberately done by the government.  Appreciation or revaluation means that less of the currency will be required to purchase  each unit of the other currency because it is now relatively stronger. Appreciation can be caused by either an increase in the demand for a currency or a decrease in the supply of the currency. In Figure 3 below, an increase in demand for the US dollar leads to the appreciation of the US dollar against the UK pound  from £5.00 per dollar to £6.00 per dollar. This means that a dollar which could be exchanged for £5 will now be exchanged for more pounds (£6). 

Figure 3: Appreciation of the US$ caused by increase in demand

A fall in supply will lead to the appreciation of the US dollar against the UK pound from £2.50 per dollar to £5.50 per dollar (Figure 4 below). In this case, a dollar can now be exchanged for more UK pound (£5.50). The UK pound, by contrast, has depreciated against the US dollar.

Appreciation increases export prices and decreases import prices, thereby encouraging importation at the expense of exportation. It will reduce current account surplus or increase current account deficit.

Figure 4: Appreciation of the US$ caused by decrease in supply

Nominal exchange rate and trade-weighted exchange rate
Exchange rate is usually expressed as one country’s currency in terms of another country’s currency. This is the nominal exchange rate as it states how much of a single country’s currency can  be bought with another single country’s currency.

Sometimes, a currency can be stated in terms of more than one other country’s currency using the volume of trade as the weights;  this is known as trade weighted exchange rate. It is usually expressed in the form of an index. The base is 100 and the movement in the exchange rate can be determined by the total weighted change against the currencies of trading partners. For instance, the volume of trade of Nigeria with the USA is 40% and the volume of trade with China is 60%. The Nigerian trade weighted exchange rate index  will now be  138 (100 + 38) if its currency (naira) gains 20% against the American dollar and rises by 50% against the Chinese Yuan.  The calculations are shown below.

Real exchange rate
It is the exchange rate obtained after making adjustment for inflation in the two countries involved. It shows the purchasing power of a country’s currency as the difference between the domestic and foreign price levels is considered. It helps determine the price competitiveness of a country’s products. Even though the nominal exchange rate does not change, a higher inflation rate in a foreign country will weaken the purchasing power of a home country’s currency as foreign prices have risen. An adjustment to the nominal exchange rate that takes into account  changes in price levels in both countries is the real exchange rate. The formula for calculating real exchange rate is: 

Nominal exchange rate   x  price index in home country
                                                ————————————————–
                                                 price index in foreign country

Marshall-Lerner Condition
A fall in the exchange rate through devaluation will reduce export prices and increase import prices.  Export volume will increase while imports will reduce. This is capable of reducing current account deficit if value of exports exceeds value of imports. The price elasticity of demand (PED) of exports and PED of  imports are very important. If exports of a country are price elastic, a price reduction would increase export revenue because export volume will rise by a greater percentage.  If imports are price elastic, an increase in price will reduce import expenditure. But if imports are price inelastic, a rise in price will increase import expenditure. Exports have to price elastic for devaluation to reduce current account deficit. Imports may be elastic or not as a large export revenue can offset a rise in import expenditure.

The Marshall-Lerner condition stipulates the condition under which currency devaluation will be effective in reducing a current account deficit. It states that devaluation will reduce the deficit only if the sum of the PED of exports and PED of imports is greater than one. If the sum of their PED is less than one, devaluation will not reduce the deficit. In this case, revaluation will work. Revaluation increases the price of exports and reduces the price of imports.

J-Curve Effect
J-Curve effect states that a  fall in the exchange rate through  devaluation or depreciation would worsen trade deficit  first before it starts reducing it. It will take some time before there is a rise in export quantity and a cut in import quantity as a result of  a decrease in export prices and increase in import prices. Therefore, exports and imports tend to more price inelastic in the short run. But they tend to be more price elastic over the long run.

Figure 5: J-Curve effect