Revise Exchange rates for Cambridge 9708 (11.2)

Beyond the simple fixed versus floating dichotomy, most countries operate a managed float system. Here, the exchange rate is primarily determined by market forces, but the central bank intervenes to influence its value. This intervention involves buying or selling its own currency in the foreign exchange market to counter excessive volatility or to steer the rate towards a level that supports macroeconomic objectives. A 'dirty float' is a term often used to describe a managed float where intervention is frequent and significant, suggesting the currency is not truly floating freely. The primary goals are to maintain stability for businesses, prevent speculative attacks, and ensure export competitiveness without the rigid constraints of a fully fixed system.

The J-curve effect illustrates the time path of a country's current account balance following a currency depreciation or devaluation. Initially, the current account deficit may worsen. This is because import and export volumes are often inelastic in the short run due to pre-existing contracts and slow consumer response. Therefore, the country pays more for its imports while export revenue changes little, deepening the deficit. Over time, as demand for both exports and imports becomes more price elastic, consumers and firms adjust their behaviour. Cheaper exports lead to a significant rise in export volume, while more expensive imports lead to a fall in import volume. This eventually leads to an improvement in the current account balance, tracing the shape of the letter 'J'.

For a currency depreciation or devaluation to successfully improve the current account balance, the Marshall-Lerner condition must be satisfied. This condition states that the sum of the price elasticity of demand for exports (PEDx) and the price elasticity of demand for imports (PEDm) must be greater than one (i.e., PEDx + PEDm > 1). If the condition holds, the increase in export revenue and decrease in import expenditure from changing volumes will outweigh the negative price effects, leading to a net improvement in the trade balance. If the sum is less than one, a devaluation would worsen the current account. This condition provides the theoretical underpinning for the eventual upward swing of the J-curve.

Purchasing Power Parity (PPP) is a long-run theory of exchange rate determination. The absolute version states that the exchange rate between two currencies should equalise the price of an identical basket of goods and services in each country, based on the 'law of one price'. The relative version suggests that the rate of change in the exchange rate should offset the difference in inflation rates between two countries. For example, if UK inflation is 5% and US inflation is 2%, the pound should depreciate by approximately 3% against the dollar. While a useful theoretical benchmark, PPP often fails to hold in reality due to transport costs, trade barriers, non-traded goods, and the significant influence of short-term capital flows and speculation.

Governments face significant policy conflicts when managing the exchange rate. A policy of maintaining a strong exchange rate (appreciation) helps to control inflation by making imports cheaper and forcing domestic firms to remain competitive. However, it harms exporters by making their goods more expensive abroad, potentially leading to a worsening current account and unemployment in export-oriented industries. Conversely, engineering a weak exchange rate (depreciation) can boost export-led growth and employment but risks importing inflation as the cost of imported raw materials and consumer goods rises. This dilemma highlights the trade-off between internal objectives (like low inflation) and external objectives (like a stable current account balance), forcing policymakers to prioritise.