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 offset by a financial account deficit
or vice versa. Under fixed exchange rates, a balance of payments surplus or deficit must be
matched by an offsetting 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 the 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 net foreign assets are, the higher is the inflow of interest income, and
the higher is the real exchange rate needed to maintain external balance.
