The exchange rate policy refers to the manner in which a country manages its currency in respect to foreign currencies and the foreign exchange market. The exchange rate is the rate at which the domestic currency can be converted into a foreign currency. In turn, this affects the costs of domestic production and finance relative to foreign products and capital. In formulating exchange rate policy, a balance must be found between several differing, and sometimes conflicting, objectives. In particular, the use of the exchange rate to promote the competitiveness of domestically-produced goods must be considered alongside the implication for the international purchasing power of the currency and, in particular, the impact of changes in the exchange rate on domestic inflation.
Some Definitions
- Exchange rate:the price of one currency in terms of another.
- Nominal exchange rate:the actual exchange rate at which currencies are exchanged on the foreign exchange market.
- Real exchange rate:the nominal exchange rate adjusted for inflation differentials.
- Floating exchange rate:an exchange rate which is solely determined by the forces of demand for and supply of domestic currency with no intervention by the monetary authorities.
- Pegged exchange rate:an exchange rate system in which the value of the domestic currencyis set relative to another currency or a basket (combination) of currencies; changes to the peg are made through discrete (i.e., step-like) adjustments.
- Managed float:an exchange rate system where the authorities have the discretion to intervene in the foreign exchange markets to guide the value of the domestic currency.
- Crawling peg/band mechanism:an exchange rate system where the value of the domestic currency is adjusted on a regular basis according to a pre-determined formula that takes account of, for example, actual or expected inflation differentials. If the rate of adjustment (or crawl) is determined precisely, then it is crawling peg;while, if some fluctuation allowed then it is a crawling band.
- Nominal effective exchange rate (NEER):a weighted average of bilateral nominal exchange rates, with weights typicallybased on the trade shares.
- Real effective exchange rate (REER):the NEER adjusted for inflation differentials.
- Exchange rate appreciation:a decrease in the domestic currency price of the foreign currency due to market forces or in the normal course of business.
- Exchange rate depreciation:an increase in the domestic currency price of the foreign currency due to market forces or in the normal course of business.
- Exchange rate devaluation:in a fixed exchange rate regime, a policy decision to make a discrete reduction in the value of the domestic currency.
- Exchange rate revaluation:in a fixed exchange rate regime, a policy decision to make a discrete increase in the value of the domestic currency.
- Special Drawing Rights (SDR):the official unit of account (currency) of theInternational Monetary Fund, (IMF). It is comprised of a weighted combination of the US dollar, British pound, euro, Chinese yuan and Japanese yen with the composition reviewed periodically, most recently in October 2016.
- Dutch disease:a situation where large inflows of foreign exchange cause the real exchange rate to appreciate resulting in some sectors of the economy becoming uncompetitive. A typical example is the discovery and subsequent exploitation of mineral resources: the term ‘Dutch’ refers to the impact of the discovery of natural gas had on the competitiveness of manufacturing in the Netherlands.
