The exchange rate is the number of units of foreign currency
that exchange for a unit of the domestic currency. A fall (rise) in the exchange
rate is called depreciation (appreciation).
The demand for domestic currency in the forex market arises
from exports and purchases of domestic assets by foreigners; the supply
of domestic currency to the market arises from imports and purchases
of foreign assets. Floating exchange rates equate supply
and demand for currency in the absence of government intervention in the forex
market.
Under fixed exchange rates, the government meets an excess
supply of pounds by running down foreign currency reserves in order to prompt
demand for pounds. An excess demand for pounds, at the fixed exchange rate,
raises the foreign exchange reserves as pounds are supplied to the market.
In the balance of payments accounts, monetary inflows
are credits and monetary outflows are debits. The current account
shows the trade balance plus current transfer payments, which largely reflect
income earned from assets owned in other currencies, payment of international
subsidies and social security payments. The capital account records the transfers
of capital by migrants, debt forgiveness and net grant receipts for infrastructure
projects from overseas institutions. Typically, this is small and for convenience
we often ignore it completely. The financial account shows
net purchases and sales of foreign assets. The balance of payments is the
sum of the current, capital and financial account balances.
Under floating exchange rates, a current surplus must be off set by a financial
account deficit or vice versa. Under fixed exchange rates, a balance of payments
surplus or deficit must be matched by an off setting quantity of official
financing. Official financing is government intervention
in the forex market.
The real exchange rate adjusts the nominal exchange rate
for prices at home and abroad, and is the relative price of domestic to foreign
goods when measured in a common currency. A rise in the real exchange rate
reduces the competitiveness of the domestic economy.
The purchasing power parity is path of the nominal exchange
rate that would keep the real exchange rate at its initial level.
An increase in domestic (foreign) income increases the demand for imports
(exports). An increase in the real exchange rate reduces the demand for exports,
increases the demand for imports and reduces the demand for net exports.
Holders of international funds compare the domestic interest rate with
the total return from temporary lending abroad. This return is the foreign
interest rate plus the depreciation of the international value of the domestic
currency during the loan. Perfect international capital mobility means that
an enormous quantity of funds shift between currencies when the perceived
rate of return differs across currencies.
The interest parity condition says that, when capital mobility is perfect,
interest rate differentials across countries should be offset by expected
exchange rate changes, so that the total expected return is equated across
currencies.
Internal balance means output is at potential output. External
balance means the current account equals zero. Long-run equilibrium
needs both.
Given domestic and foreign levels of potential output, there is a unique
real exchange rate that achieves trade balance. An increase in domestic potential
output, for example from a resource discovery, causes a real exchange rate
appreciation to maintain trade balance in the long run.
Interest flows from foreign assets and debts make the current account differ
from the trade balance. The higher are net foreign assets, the higher is the
inflow of interest income and the higher is the real exchange rate needed
to maintain external balance.
