exchange rate policy

Effectiveness of Exchange‑Rate Policy (Cambridge 9708 – 10.3)

1. Policy Objectives (syllabus wording)

• Economic growth
• Price stability (inflation control)
• Unemployment
• External balance (current‑account)
• Distribution of income

When evaluating any exchange‑rate policy we must assess how well it helps achieve each of the five objectives (AO2 – analysis, AO3 – evaluation).

2. Measuring Exchange Rates

2.1 Nominal exchange rate (e_n)

• Definition: number of units of domestic currency required to buy one unit of foreign currency.
• Example: £1 = US$1.30 → e_n = 0.77 £/US$.

2.2 Real exchange rate (e)

Adjusts the nominal rate for relative price levels:

\[ e = e_{n}\times\frac{P_{\text{domestic}}}{P_{\text{foreign}}} \]

• e > 1 → domestic goods are relatively expensive (real appreciation).
• e < 1 → domestic goods are relatively cheap (real depreciation).

2.3 Trade‑weighted exchange‑rate index

• Weighted average of bilateral nominal rates, weights based on the share of each partner in total trade.
• Useful for assessing overall competitiveness when a country trades with many partners.

3. Revaluation and Devaluation

• Revaluation: official upward adjustment of a fixed or pegged nominal rate (the domestic currency appreciates, e_n falls).
• Devaluation: official downward adjustment of a fixed or pegged nominal rate (the domestic currency depreciates, e_n rises).

Examples

• 1994 China – RMB revalued from 8.62 CNY/$ to 8.28 CNY/$ (≈4 % appreciation). Export competitiveness fell, contributing to a slowdown in export‑led growth.
• 1994 Mexico – “Tequila Crisis”. A sudden devaluation of the peso from 3.4 MXN/$ to 7.2 MXN/$ was intended to restore competitiveness but triggered a severe recession and loss of credibility.

4. Exchange‑Rate Regimes (syllabus list)

1. Fixed (or pegged) exchange rate
   • Conventional peg – single anchor currency or basket.
   • Crawling peg – the peg is adjusted regularly (e.g., daily or monthly) by a small, pre‑announced amount.
   • Currency board – domestic currency is 100 % backed by foreign reserves; the board issues domestic notes only against foreign currency at a fixed rate.
2. Floating (flexible) exchange rate – market determines the rate; central bank intervenes only to prevent disorderly movements.
3. Managed (or “dirty”) float – market‑determined rate with occasional official intervention to smooth volatility or achieve a target real rate.

Capital controls (e.g., limits on capital flows) can be combined with any of the above regimes and are explicitly mentioned in the syllabus as a tool that may affect effectiveness.

5. Effectiveness of Each Regime – Impact on the Five Objectives

Regime	Economic Growth	Price Stability	Unemployment	External Balance	Distribution of Income	Key Limitations
Conventional Fixed Peg	Exchange‑rate certainty reduces transaction costs → encourages FDI and investment. Devaluation can give a short‑run boost to net exports (NX) and output.	Import prices are predictable if the anchor currency is stable. Devaluation may import inflation (higher import‑price level).	Devaluation can lower cyclical unemployment via higher output. Rigid peg may delay labour‑market adjustments when the external environment changes.	Adjustable peg (devaluation/revaluation) can correct persistent deficits or surpluses. Inflexible peg can lock the economy into an unsustainable current‑account position.	Export‑oriented sectors benefit; import‑dependent households may face higher living costs after a devaluation.	Requires large foreign‑exchange reserves. Vulnerable to speculative attacks (e.g., 1992 UK ERM crisis). Loss of monetary independence.
Crawling Peg	Predictable, gradual adjustments avoid the shock of a sudden devaluation, supporting steady growth. Can be used to maintain competitiveness without large discrete moves.	Small, regular adjustments limit abrupt import‑price spikes, helping price stability.	Gradual depreciation can reduce unemployment without the uncertainty of a pure float.	Continuous, modest devaluation helps correct a persistent current‑account deficit while avoiding overshooting.	Less disruptive for households; the slow change spreads distributional effects over time.	Requires credible commitment to the crawl schedule; otherwise markets may anticipate larger moves. Still needs adequate reserves.
Currency Board	Strong credibility attracts long‑term investment; the fixed rate provides a stable environment for growth. Lack of discretionary devaluation removes a tool for short‑run stimulus.	Import prices are fully anchored to the anchor currency → excellent price stability.	Unemployment may be higher if the fixed rate is over‑valued because the external sector cannot adjust.	Current‑account imbalances are corrected only through real‑price adjustments (wages, productivity).	Distributional impact depends on the real exchange‑rate level; an over‑valued board can hurt low‑income import‑dependent groups.	Requires 100 % foreign‑reserve backing – costly to maintain. No monetary policy freedom; cannot act as a shock absorber.
Floating	Automatic adjustment to external shocks can sustain growth. High volatility may deter investment and raise risk premia.	Exchange‑rate movements are passed on to import prices → possible inflationary spikes.	Automatic depreciation in a recession can lower unemployment. Uncertainty may increase structural unemployment if firms postpone hiring.	Balance‑of‑payments mechanism drives the current account toward equilibrium (Mundell‑Fleming adjustment).	Effects are dispersed; no specific group is deliberately helped or harmed.	Limited control for the government to correct persistent imbalances. Potential for destabilising volatility.
Managed Float	Targeted intervention smooths short‑run volatility → maintains investor confidence. Temporary devaluation can give a short‑run boost to NX without full exposure to market swings.	Central bank can intervene to prevent sharp import‑price spikes, aiding price stability.	Reduces cyclical unemployment while limiting uncertainty.	Gradual adjustments avoid the “overshooting” problem of a pure float.	Discretion allows support for vulnerable sectors (e.g., agricultural exporters).	Risk of “policy inconsistency” if interventions appear arbitrary. Credibility depends on clear rules and transparent communication.

5.1 Capital Controls (optional add‑on)

• When used with a peg or managed float, controls limit capital‑flight and reduce the size of speculative attacks.
• They may dampen the transmission of monetary policy, creating a trade‑off between exchange‑rate stability and financial integration.

6. Trade‑off (Pros/Cons) Matrix

Objective	Typical Trade‑off
Economic Growth	Higher growth via devaluation ↔ risk of imported inflation.
Price Stability	Stable exchange rate ↔ loss of monetary‑policy autonomy.
Unemployment	Depreciation lowers cyclical unemployment ↔ may increase structural unemployment if firms face uncertainty.
External Balance	Devaluation improves the current account if the Marshall‑Lerner condition holds ↔ can worsen the balance if elasticities are low.
Distribution of Income	Export‑oriented workers benefit from a weaker currency ↔ import‑dependent low‑income households suffer higher prices.

7. Marshall‑Lerner Condition & the J‑Curve

7.1 Marshall‑Lerner Condition

A real depreciation improves the trade balance only if the sum of the absolute price elasticities of export (|η_X|) and import (|η_M|) demand exceeds one:

\[ |η_X| + |η_M| \; > \; 1 \]

• If the condition holds, the increase in export revenue outweighs the higher cost of imports → net exports rise.
• If the condition fails (elasticities too low), a depreciation may worsen the trade balance.
• Exam tip: In data‑table questions, calculate the percentage change in export and import volumes, compare with the percentage change in the real exchange rate, and check whether the inequality is satisfied.

7.2 The J‑Curve Effect

• Short‑run: import quantities are price‑inelastic, so the value of imports rises faster than export revenue → trade balance deteriorates.
• Medium‑ to long‑run: quantities adjust, the Marshall‑Lerner condition becomes operative, and the trade balance improves, producing a “J‑shaped” trajectory.

Diagram suggestion: Plot trade‑balance (vertical axis) against time after a devaluation, showing an initial dip followed by a rise.

8. Interaction with Fiscal and Monetary Policy (Mundell‑Fleming framework)

Policy Interaction	Typical Effect (high capital mobility)	Typical Effect (low capital mobility)	Potential Conflict
Monetary policy – lower interest rates	Capital outflows → depreciation → boost to NX.	Smaller capital‑flow response; effect on exchange rate muted.	If the central bank simultaneously raises rates to fight inflation, the depreciation stimulus may be neutralised.
Fiscal policy – expansionary spending	Higher aggregate demand raises import demand, offsetting the export gain from a depreciation.	Impact on imports is weaker; the exchange‑rate effect may dominate.	Contractionary fiscal policy can reinforce a devaluation‑induced stimulus to output but may raise unemployment.
Fixed peg – monetary policy subordinated	To defend the peg, the central bank may need to raise rates (capital inflows) even if domestic conditions call for easing.	With capital controls, the need for rate adjustments is reduced, giving some monetary freedom.	Loss of monetary independence limits the ability to target inflation or growth directly.

9. Limits of Exchange‑Rate Policy & Government Failure

• Reserve constraints – a fixed peg can be defended only while sufficient foreign‑exchange reserves are available.
• Speculative attacks – doubts about sustainability can trigger rapid capital outflows (e.g., 1992 UK ERM crisis).
• Policy lags – effects on output, unemployment and the trade balance may take several quarters to materialise.
• Impossible (Unholy) Trinity – a country cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy.
• Government failure
  • Poor timing or politically motivated devaluations can erode credibility (e.g., Argentina 2001 – multiple ad‑hoc devaluations).
  • Lack of transparent rules may lead to “policy inconsistency” and higher market uncertainty.
• External shocks – commodity‑price swings, global financial crises or sudden changes in terms of trade can overwhelm any exchange‑rate strategy.

10. Practical Considerations for Policy‑Makers

1. Reserve adequacy – maintain a buffer of foreign‑exchange assets to defend a peg or intervene in a managed float.
2. Credibility and communication – clear, consistent statements reduce speculative pressure and improve the effectiveness of any regime.
3. Policy coordination – align exchange‑rate moves with monetary and fiscal stances; avoid offsetting actions.
4. Assess export and import elasticities – use historical data to judge whether the Marshall‑Lerner condition is likely to hold.
5. Plan for the J‑curve – expect a short‑run deterioration in the trade balance after a devaluation; consider temporary measures (export credit, import‑substitution support) to accelerate adjustment.
6. Capital‑flow management – where appropriate, employ capital controls to limit speculative attacks while preserving enough openness for investment.
7. Institutional capacity – transparent foreign‑exchange market infrastructure and an independent central bank are essential for a credible managed float or currency board.

11. Summary

• Exchange‑rate policy can influence all five macro‑objectives, but its success depends on the chosen regime, the surrounding fiscal‑monetary mix, and the country’s institutional strengths.
• Fixed pegs (including crawling pegs and currency boards) provide stability and attract investment but require large reserves and sacrifice monetary independence.
• Floating rates offer automatic external‑adjustment but can be volatile and limit the government’s ability to correct persistent imbalances.
• Managed floats aim to combine stability with flexibility; their effectiveness hinges on credible, rule‑based intervention.
• Devaluation is only beneficial when the Marshall‑Lerner condition holds; the J‑curve reminds us that the trade‑balance improvement is usually delayed.
• Interaction with monetary and fiscal policy, the “impossible trinity”, and the risk of government failure are critical limits that must be managed carefully.