Unit 5 Macroeconomic policy: Inflation and unemployment
5.14 Monetary policy and the exchange rate
- policy (interest) rate
- The nominal interest rate set by the central bank, which applies to banks that borrow base money from each other, and from the central bank. Also known as: base rate, official rate. See also: real interest rate, nominal interest rate.
- nominal exchange rate
- The number of units of the home currency that have to be exchanged to obtain one unit of a foreign currency—that is, the market exchange rate—is described as a nominal exchange rate to distinguish it from the real exchange rate, which is the relative price of foreign and domestic goods and services. See also: real exchange rate.
In many economies, a crucial channel for monetary policy is the exchange rate—the rate at which the currency can be exchanged for foreign currency. Changes in the policy interest rate lead to changes in the exchange rate and competitiveness, and hence change net exports, output, and employment. A change in the exchange rate also has a direct impact on inflation, through import prices.
Defining the nominal exchange rate
When working with exchange rates, it is helpful to take the point of view of one specific country, the home economy, and also to focus on a particular foreign economy. We use the conventional definition in economics:
The nominal exchange rate, \(e\), is the number of units of home currency that have to be exchanged for one unit of foreign currency.
This definition of the exchange rate is used by most economists today. But you need to be careful, because the opposite definition (foreign currency per unit of home currency) has been used in the past and is still used in some contexts. For example, in the UK media, the UK’s exchange rate is typically quoted in dollars per pound—reflecting the UK’s historical dominance in financial markets.
In other words, \(e\) is the price that residents of the home country have to pay for each unit of the foreign currency. We call it the nominal exchange rate because it is measured in currency units.
Suppose that the home economy is Australia, and the foreign country is the US. Then Australia’s exchange rate \(e\) is the number of Australian dollars per US dollar (AUD/USD). For example, on 1 August 2024 you could obtain 1 US dollar in return for 1.54 Australian dollars: \(e = 1.54\). If a business in Australia had bought equipment costing 5000 USD from the US on that day, it would have paid \(5000 \times 1.54 = 7700\) AUD.
Appreciation and depreciation
If Australia’s exchange rate, \(e\), increases, you need more Australian dollars to buy one US dollar. For an Australian buying imported goods made in the USA (or priced in US dollars), the price in Australian dollars goes up.
- depreciation (of a currency), nominal depreciation
- If the number of units of the home currency that have to be exchanged to obtain one unit of a foreign currency increases, the home currency is said to have depreciated relative to the foreign currency. This is sometimes described as a nominal depreciation; it corresponds to an increase in the conventional measure of the nominal exchange rate. See also: exchange rate, real depreciation.
If this happens, we say that the Australian dollar has depreciated against the US dollar, because one AUD buys you less of anything measured in US dollars—Australian dollars are worth less, relative to US dollars. (From the viewpoint of the US, the US dollar has appreciated against the Australian dollar.)
- appreciation, nominal appreciation
- If the number of units of the home currency that have to be exchanged to obtain one unit of a foreign currency decreases, the home currency is said to have appreciated relative to the foreign currency. This is sometimes described as a nominal appreciation; it corresponds to an decrease in the conventional measure of the nominal exchange rate. See also: exchange rate, real appreciation.
Conversely, a decrease in \(e\) corresponds to an appreciation of the Australian dollar against the US dollar.
| Nominal exchange rate, e = units of home currency per unit of foreign currency | ||||
|---|---|---|---|---|
| home currency depreciates | e increases | foreign currency costs more | ||
| home currency appreciates | e decreases | foreign currency costs less | ||
Unhelpfully, commentators in the media often refer to home’s exchange rate ‘rising’, when they mean that home’s currency has appreciated. And it may not be clear whether they have defined the exchange rate as above, or in the opposite way. We can remove ambiguity by saying that ‘the home currency appreciates’, or ‘home’s exchange rate appreciates’ rather than ‘the exchange rate falls’.
When using exchange rates in practical applications, our strong recommendation is: don’t use the words ‘up’ and ‘down’ or ‘rising’ and ‘falling’! Check carefully how the exchange rate is defined in the data you are using. Then use the unambiguous terms ‘depreciation’ or ‘appreciation’ when you interpret the data.
Question 5.11 Choose the correct answer(s)
The following is a table of the British pound (GBP) exchange rate against the dollar (USD) and euro (EUR), using values reported by the Bank of England:
| 8 Feb 2023 | 8 Feb 2024 | |
|---|---|---|
| GBP/USD | 0.8280 | 0.7933 |
| GBP/EUR | 0.8879 | 0.8538 |
In this table, the exchange rates are defined as the number of GBP per USD or per EUR. Based on this information, read the following statements and choose the correct option(s).
- 1 USD was worth 0.83 GBP on 8 February 2023 and worth 0.79 GBP one year later, so the USD depreciated against the GBP.
- 1 EUR was worth 0.85 GBP compared to 0.89 GBP one year earlier, so the EUR depreciated against the GBP.
- The USD depreciated relative to the GBP over the period, so exports of British goods became more expensive (from the perspective of US consumers).
- The EUR became cheaper relative to the GBP over the year, so goods imported from Europe also became cheaper.
Real exchange rates and the impact on net trade
The nominal exchange rate \(e\) is measured in currency units—for example, the price in Australian dollars of one US dollar. But to understand its implications for the economy, we need to look at the real exchange rate, which is the relative price of foreign and domestic goods and services.
If \(P\) is the price of goods and services in the home economy, and we write \(P^*\) for the price level in the foreign economy, we can’t compare them directly because they are measured in different currencies. But we can convert them to the same units using the nominal exchange rate, \(e\). We will take the perspective of the home economy as before, and write both prices in terms of domestic currency:
- Price of domestic goods and services = \(P\)
- Price of foreign goods and service = \(e \times P^*\)
- Relative price of foreign goods and services \(= \frac{e \times P^*}{P}\)
Suppose, for example, that a T-shirt imported into Australia costs 20 USD, and the nominal exchange rate of the AUD against the USD is \(e = 1.5\). Then you need 1.5 AUD to buy each USD, so the price of the T-shirt in Australian dollars is \(1.5 \times 20 = 30\) AUD. If a T-shirt made in Australia cost 25 AUD, then the relative price of US T-shirts is \(30/25 = 1.2\) (in other words, US T-shirts cost 20% more).
- real exchange rate, competitiveness
- The relative price of foreign and domestic goods and services; specifically, it is the price of foreign goods and services, converted into domestic currency at the market (nominal) exchange rate, divided by the price of domestic goods and services. The real exchange rate is a measure of competitiveness.
When we estimate the relative price of foreign goods in the data for the economy as a whole, price levels \(P\) and \(P^*\) are measured by the same consumer price indexes used by central banks to target inflation, and the relative price \(eP^*/P\) is called the real exchange rate of the home economy.
We would get the same answer for the real exchange rate if we evaluated the two prices in terms of the foreign currency. The relative price is simply a number—the ratio of two prices measured in the same units.
If Australia’s real exchange rate relative to the US is 1.15, for example, it tells us that a basket of goods imported from the US costs 15% more than a basket of goods produced in Australia. And it also tells us that Australian goods are competitive in foreign markets: they are cheaper for foreign buyers than goods produced in the US. Thus the real exchange rate is a measure of the country’s competitiveness in world markets, and we label it ‘\(c\)’ as a reminder:
\[\text{real exchange rate, } c = \frac{e \ \times \ P^*}{P} \\ \text{(Increase in } c \text{ is a real depreciation)}\]- real depreciation, real appreciation
- A country experiences a real depreciation if its real exchange rate (measured as the relative price of foreign goods and services, also known as competitiveness) increases. Likewise a fall in competitiveness is a real appreciation. See also: real exchange rate.
Just as an increase in \(e\) represents a nominal depreciation (the price of foreign currency goes up relative to domestic currency), an increase in competitiveness \(c\) is a real depreciation (the price of foreign goods goes up relative to domestic goods). This could result either from a change in the price level of one of the countries, or a nominal depreciation. A real depreciation makes the home economy more competitive. Likewise a decrease in \(c\) is a fall in competitiveness and a real appreciation.
| $$ \text{real exchange rate, } c = \frac{e \times P^*}{P} $$ | ||
|---|---|---|
| real depreciation | c increases | competitiveness rises |
| real appreciation | c decreases | competitiveness falls |
We would typically expect a real depreciation to boost domestic output, since the relative price of goods and services produced abroad has risen, making imports \(M\) more expensive and exports \(X\) more competitive. In the home economy, demand for imports will fall and demand from abroad for its exports will rise. Thus we would expect a real depreciation (for example due to a nominal depreciation) to increase net exports \(X − M\), and hence boost aggregate demand, output \(Y\) and employment \(N\).
Figure 5.21 A depreciation of the home economy’s real exchange rate raises output and employment.
The evidence for this linkage is strong. In Unit 7, we discuss it in more detail and show that the distinction between changes in nominal and real exchange rates can be extremely important, especially in countries where inflation rates are very different.
Inflation targeting and the exchange rate
The effect of changes in the exchange rate on aggregate demand through net exports provides an important channel for the transmission of monetary policy. In a modern inflation-targeting regime central banks do not attempt to control the exchange rate, which is set in foreign exchange markets. But they take into account how changes in the policy interest rate may influence the exchange rate. How does this mechanism work?
Consider the case of a slowdown in the Australian economy caused by a decline in investment demand, and assume the economy begins with inflation at target. Since the slowdown is likely to reduce inflation, the Reserve Bank of Australia faces no conflict with its inflation target. Stabilizing aggregate demand by cutting the policy interest rate will help bring inflation back up to target.
The cut in the policy rate reduces returns on Australian financial assets. If interest rates outside Australia are unchanged, the central bank will expect this to make Australian financial assets less attractive to international investors, resulting in a depreciation of the Australian dollar. The basic logic is that to buy Australian financial assets, you need AUD. If the demand for the assets falls, so does the demand for AUD, causing a depreciation.
Referring back to the definition of the real exchange rate, if inflation both in Australia and abroad are at similar rates, the ratio of \(P^*\) to \(P\) won’t change. Then the only change is the nominal depreciation (increase in \(e\)) which will imply a real depreciation (increase in \(c\)). If this happens, goods produced in Australia will become more competitive, boosting exports (\(X\)) and depressing imports (\(M\)). The increase in net trade (\(X – M\)) will boost aggregate demand and help to stabilize the economy.
There are some crucial ‘ifs’ in the previous paragraphs, explored in Exercise 5.11. The extent to which monetary policy affects the exchange rate is not straightforward. But for economies that have direct control over monetary policy, the exchange rate mechanism can in practice play an important role.
The exchange rate and inflation
We have described how the central bank’s interest rate decision affects aggregate demand both directly (through investment) and via the effect on the exchange rate and hence net exports. But, for central banks with a duty to target inflation, there is an additional impact of exchange rate changes: they directly affect the rate of inflation.
To understand why, remember the definition of the real exchange rate. The top of the ratio, \((e \times P^*)\), measures the price of foreign goods and services in domestic currency. For most small economies, nothing that happens domestically will affect the foreign price level \(P^*\). So a depreciation of the nominal exchange rate almost always has a direct impact on import prices. And imports are typically a substantial share of the basket of goods in the consumer price index targeted by the central bank. So whatever the other effects, a nominal depreciation almost always increases consumer price inflation.
Thus when the Reserve Bank of Australia cuts interest rates in response to a slowdown following a fall in investment, hoping to cause a depreciation of the Australian dollar as well as stimulating investment, then—if it occurs—the change in the exchange rate will affect the economy in two ways, illustrated in Figure 5.22. It will raise aggregate demand through the effect of net exports, but in addition it will almost certainly increase Australian inflation—back towards the bank’s target level. The central bank will certainly take import prices into account when setting monetary policy.
Figure 5.22 The exchange rate effects of a cut in Australia’s interest rate.
Exercise 5.11 The ‘ifs’ and ‘buts’ of monetary policy and the exchange rate
Consider some of the caveats in the discussion above:
If interest rates outside Australia are unchanged…
… if, as the Central Bank expects, the Australian dollar depreciates…
… if inflation both in Australia and abroad are at similar rates, this will imply a real depreciation.
For each caveat, describe a situation under which that condition may not be satisfied. If that condition is not satisfied, discuss whether or not the cut in Australian interest rates will work as intended (as illustrated in Figure 5.22).
