Exchange rate systems (Balance of Payments, Exchange rates and International Competitiveness)

Using the percentage-change formula, $\%\,\Delta = \dfrac{\text{new} - \text{old}}{\text{old}} \times 100$:

$\dfrac{1.35 - 1.50}{1.50} \times 100 = \dfrac{-0.15}{1.50} \times 100 = -10\%$

The pound has fallen by 10% against the dollar (a depreciation) (2).

A depreciation is a fall in the value of a currency in a FLOATING exchange-rate system (1), brought about by market forces — for example a fall in the demand for the currency or a rise in its supply (1).

A devaluation is also a fall in a currency's value, but it occurs in a FIXED exchange-rate system (1): it is a deliberate policy decision by the central bank to lower the pegged rate, rather than a market outcome (1).

So the direction (a fall) is the same, but the cause and system differ — depreciation is market-driven under floating; devaluation is policy-driven under a fixed peg.

A rise in a country's interest rate raises the return offered to savers relative to rates abroad. This attracts inflows of hot money — short-term financial capital that moves between countries chasing the highest return.

To place money in the country, foreign investors must first buy the currency. This raises the demand for the currency, so on a foreign-exchange market diagram — with the exchange rate on the vertical axis and the quantity of the currency on the horizontal axis — the demand curve shifts right, from D to D₁, with supply unchanged.

At the original exchange rate e₁ there is now excess demand for the currency: more buyers want it than sellers are offering at that rate. This excess demand bids the exchange rate up until the market clears at a new equilibrium, with a higher exchange rate e₂ and a larger quantity of currency traded Q₂.

The rise from e₁ to e₂ is an appreciation of the currency. Therefore a rise in interest rates, by attracting hot money and raising the demand for the currency, is likely to cause the exchange rate to appreciate — the movement up the supply curve from e₁ to e₂ shown by the shift D→D₁.

A floating exchange rate is set entirely by the market, and this brings two clear advantages.

Advantage 1 — automatic adjustment of the balance of payments. If a country runs a trade deficit, it is importing more than it exports, so the supply of its currency exceeds the demand for it. In a floating system this excess supply pushes the exchange rate down — the currency depreciates. A weaker currency makes exports cheaper for foreigners and imports dearer at home, so (provided demand is sufficiently price-elastic) exports rise and imports fall, and the deficit corrects itself without any policy action. Under a fixed rate, by contrast, a deficit is not self-correcting.

Advantage 2 — freedom to use monetary policy for domestic goals. Because the central bank is not committed to defending a peg, it does not have to set interest rates to hold the exchange rate. It can therefore set interest rates for the domestic economy — for example cutting them to support growth in a recession, or raising them to control inflation — rather than sacrificing them to the exchange rate. A fixed system surrenders this independence, because interest rates must be used to defend the peg.

Both advantages flow from the same feature: with the market setting the rate, the exchange rate absorbs external shocks automatically and frees domestic policy — though the flip side is greater exchange-rate uncertainty for traders.

A depreciation is a market fall in a floating exchange rate, so the currency buys less foreign currency. Suppose the currency falls because, say, the demand for it drops (a fall in exports or a rise in imports raising its supply). On a foreign-exchange market diagram the shift moves the equilibrium down to a lower rate e₂, and the effects on the wider economy follow.

Effect on exports and imports (the main effect). A weaker currency makes the country's exports cheaper in foreign currency and imports more expensive in domestic currency. If demand for exports and imports is price-elastic, export volumes rise and import volumes fall, so net exports increase. Because net exports are a component of aggregate demand, AD rises, boosting output, growth and employment — a common reason governments welcome (or engineer, via devaluation) a lower rate.

Effect on the balance of payments. For the same reason, a depreciation tends to improve the current-account balance, helping correct a trade deficit automatically.

Effect on inflation. Dearer imports raise the price of imported goods and of imported raw materials, pushing up firms' costs. This causes imported (cost-push) inflation, so the price level rises.

Evaluation — it depends on elasticities. The boost to net exports relies on the Marshall–Lerner condition: the combined price elasticities of demand for exports and imports must exceed 1. If demand is inelastic (e.g. the country imports essential energy it cannot easily cut), a depreciation may worsen the trade balance rather than improve it, at least at first.

Evaluation — the time frame (J-curve). Even when Marshall–Lerner holds, the current account often worsens before it improves — the J-curve. In the short run, contracts are fixed and volumes are slow to respond, so the higher import bill dominates; only later do volumes adjust and the balance improve.

Evaluation — the inflation trade-off. The growth gain must be weighed against higher inflation. If the economy is near full capacity, a depreciation may deliver mostly inflation rather than extra output; and higher inflation can erode the competitiveness gain over time.

Judgement. A significant depreciation is likely to boost growth and net exports and help correct a deficit, but at the cost of higher imported inflation — and the net effect depends on the elasticities of trade (Marshall–Lerner), the time frame (J-curve), and how close the economy is to full capacity. It is most beneficial for an economy with spare capacity and elastic trade, and most dangerous for one that is import-dependent and near capacity.

A fixed exchange-rate system is one in which the central bank pegs the currency at a chosen rate and maintains it using foreign-currency reserves and interest rates. For a developing economy — often characterised by high or volatile inflation, thin financial markets and heavy reliance on trade and foreign investment — whether to fix the exchange rate is a genuine trade-off.

The case FOR fixing. First, a fixed rate provides certainty and stability for trade and investment. Exporters, importers and foreign direct investors face less exchange-rate risk, which can encourage the export activity and inward FDI that a developing economy needs to grow. Second, a peg imposes discipline on inflation: to hold the rate, the government cannot let domestic prices or the money supply run out of control, so a credible peg can anchor inflation expectations — valuable where inflation has been high and erratic. Third, stability reduces the risk of destabilising speculation and the capital flight that can devastate a small, open developing economy. On a foreign-exchange diagram, whenever market forces push the rate off the peg, the central bank intervenes — buying the currency (adding to demand) when it is weak, or selling it (adding to supply) when it is strong — to hold the rate at the target.

The case AGAINST fixing. First, defending a peg requires large foreign-exchange reserves, which many developing economies struggle to accumulate; if the market persistently sells the currency, reserves run down and the peg can collapse in a currency crisis (as in several emerging-market crises). Second, the country loses monetary-policy independence: interest rates must be used to defend the peg, so they cannot be set freely to manage domestic growth or unemployment — costly for an economy that needs flexibility. Third, a fixed rate provides no automatic correction of a trade deficit: unlike a floating rate, which depreciates to restore competitiveness, a pegged rate leaves a deficit to be dealt with by painful deflation or an eventual devaluation. Fourth, if domestic inflation stays above trading partners', the real exchange rate becomes overvalued, eroding competitiveness and building pressure that eventually breaks the peg.

Evaluation and judgement. Whether a developing economy should fix its rate depends on its circumstances. A fixed (or tightly managed) rate is most attractive where the priority is to import monetary credibility and tame high inflation, where the economy is small and very open and values trade certainty, and where the country can secure adequate reserves (or credible external backing). It is dangerous where reserves are thin, where the country faces frequent external shocks requiring an independent monetary response, or where domestic inflation cannot realistically be held to partners' levels — there, a floating or managed float that allows automatic adjustment and policy freedom is safer. The impossible trinity frames the core cost: with open capital markets, fixing the rate means surrendering monetary independence. For many developing economies the pragmatic answer is therefore a managed float — capturing some of the stability of a peg while retaining room to adjust — rather than a rigid fixed rate. The strongest conclusion commits to this context-dependent verdict rather than a flat 'fix' or 'float'.