Module IX·Article II·~2 min read
Exchange Rates and Regimes
Open Economy and Currencies
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Exchange Rates: Nominal and Real
The exchange rate—the price of one currency expressed in units of another—is one of the most important macroeconomic variables for open economies. The dynamics of the exchange rate affect export competitiveness, the cost of imports, inflation, and the returns on foreign investments.
Nominal and Real Exchange Rates
The nominal exchange rate is the relative price of currencies, observed on the foreign exchange market. The quotation can be direct (units of foreign currency per unit of domestic currency) or indirect (units of domestic currency per unit of foreign currency). The real exchange rate adjusts the nominal rate for the difference in price levels:
$ RER = E \times \frac{P^*}{P} $
where $E$ is the nominal rate, $P^*$ is the price level abroad, and $P$ is the domestic price level. The real rate reflects the relative prices of domestic and foreign goods and determines competitiveness.
The real effective exchange rate (REER) is the weighted average real rate relative to a basket of currencies of trade partners. REER is a comprehensive indicator of international competitiveness.
Exchange Rate Regimes
Fixed exchange rate: The central bank maintains the rate at a certain level by intervening in the foreign exchange market. Advantages—stability, low inflation, reduced transaction costs. Disadvantages—loss of monetary autonomy, risk of speculative attacks, accumulation of imbalances.
Floating exchange rate: The rate is determined by supply and demand on the currency market. Advantages—monetary autonomy, automatic adaptation to shocks. Disadvantages—volatility, uncertainty for trade and investment.
Managed float: An intermediate regime where the rate is mostly floating, but the central bank occasionally intervenes to smooth fluctuations or achieve certain goals.
The Impossible Trinity
The principle of the impossible trinity (impossible trinity) asserts that a country cannot simultaneously have a fixed exchange rate, free capital movement, and independent monetary policy. Only two out of three goals are achievable. With a fixed rate and free capital movement, the central bank is forced to follow the monetary policy of the anchor country. Independent policy with open capital flows is possible only with a floating rate.
Application for Investors
The exchange rate regime determines currency behavior. With a fixed rate, volatility is low, but there is a risk of discrete devaluations. With a floating rate, volatility is higher, but adaptation is smoother.
The real rate is informative for assessing competitiveness. An overvalued real rate (high REER) worsens competitiveness and may create pressure for devaluation. An undervalued rate supports exports.
Currency risk is an important factor for international investments. The return on foreign assets in the national currency consists of the return in the local currency and the change in the exchange rate.
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