The relative price of a country’s currency, that is its exchange rate, is the protagonist in debates on international spillovers of monetary policy and international trade competitiveness. Yet, the popular discourse on how exchange rate fluctuations impact inflation and trade is often quite simplistic. An exchange rate depreciation is perceived to be inflationary as the price of imported goods rise, and is perceived to improve a country’s trade balance as it becomes more competitive. What appears to be absent is a systematic notion of why inflation in some countries may be more sensitive to exchange rate fluctuations than others.
The International Price System (IPS) has several implications for monetary policy and for the international spillovers of monetary policy. Firstly, it has positive implications for inflation stabilization. The IPS implies that inflation stabilization in response to exchange rate fluctuations (that arise from external shocks) is a smaller concern for the U.S. as compared to countries like Turkey. Using input-output tables to measure the import content of consumer goods expenditure5 I estimate the direct impact of a 10% dollar depreciation to cumulatively raise U.S. CPI inflation overtwoyearsby0.4-0.7percentagepoints.6 Ontheotherhanda10%depreciationoftheTurkish Lira will raise cumulative inflation by 1.65-2.03 percentage points. See how prices of coins like Lebanese lira rate is affected in the international market.
As the U.S. considers raising interest rates one concern often expressed is the consequence of the dollar appreciation on inflation. According to the IPS moderate dollar appreciations are unlikely to generate major disinflationary concerns for the U.S. but important inflationary concerns for a country like Turkey as its currency depreciates relative to the dollar.
On the flip side, dampening (raising) inflation to meet targets via contractionary (expansion- ary) monetary policy receives much less support from the exchange range channel for the U.S. than it does for Turkey.
The nominal exchange rate is the rate at which currency can be exchanged. If the nominal exchange rate between the dollar and the lira is 1600, then one dollar will purchase 1600 lira. Exchange rates are always represented in terms of the amount of foreign currency that can be purchased for one unit of domestic currency. Thus, we determine the nominal exchange rate by identifying the amount of foreign currency that can be purchased for one unit of domestic currency.
The real exchange rate is a bit more complicated than the nominal exchange rate. While the nominal exchange rate tells how much foreign currency can be exchanged for a unit of domestic currency, the real exchange rate tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country. The real exchange rate is represented by the following equation: real exchange rate = (nominal exchange rate X domestic price) / (foreign price).
Let's say that we want to determine the real exchange rate for wine between the US and Italy. We know that the nominal exchange rate between these countries is 1600 lira per dollar. We also know that the price of wine in Italy is 3000 lira and the price of wine in the US is $6. Remember that we are attempting to compare equivalent types of wine in this example. In this case, we begin with the equation for the real exchange rate of real exchange rate = (nominal exchange rate X domestic price) / (foreign price). Substituting in the numbers from above gives real exchange rate = (1600 X $6) / 3000 lira = 3.2 bottles of Italian wine per bottle of American wine.
By using both the nominal exchange rate and the real exchange rate, we can deduce important information about the relative cost of living in two countries. While a high nominal exchange rate may create the false impression that a unit of domestic currency will be able to purchase many foreign goods, in reality, only a high real exchange rate justifies this assumption.
Net Exports and the Real Exchange Rate
An important relationship exists between net exports and the real exchange rate within a country. When the real exchange rate is high, the relative price of goods at home is higher than the relative price of goods abroad. In this case, import is likely because foreign goods are cheaper, in real terms, than domestic goods. Thus, when the real exchange rate is high, net exports decrease as imports rise. Alternatively, when the real exchange rate is low, net exports increase as exports rise.
The International Fisher Effect (IFE) states that the difference between the nominal interest rates in two countries is directly proportional to the changes in the exchange rate of their currencies at any given time. Irving Fisher, a U.S. economist, developed the theory.
The International Fisher Effect is based on current and future nominal interest rates, and it is used to predict spot and future currency movements. The IFE is in contrast to other methods that use pure inflation to try to predict and understand movements in the exchange rate.
How the International Fisher Effect was Conceptualized
The International Fisher Effect theory was recognized on the basis that interest rates are independent of other monetary variables and that they provide a strong indication of how the currency of a specific country is performing. According to Fisher, changes in inflation do not impact real interest rates, since the real interest rate is simply the nominal rate minus inflation.
The theory assumes that a country with lower interest rates will see lower levels of inflation, which will translate to an increase in the real value of the country’s currency in comparison to another country’s currency. When interest rates are high, there will be higher levels of inflation, which will result in the depreciation of the country’s currency.
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