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Exchange rate: The price or cost of one currency (DC or FC) in terms of another (FC or DC)
e.g.
DC/FC = Domestic currency per unit of foreign currency
$ 2.510/£ = 2.510 Dollars per one unit of pound.
Nominal Exchange Rate: $2.510/£ means one pound unit can purchase 2.510 units of U.S. dollars.
Real Exchange: It shows the dollar cost of purchasing same unit of goods/services based on
relative price levels among two countries & the current dollar/pound exchange rate.
Real exchange rate (d/f) = nominal exchange rate (d/f) ×
All else constant:
(↓) ↑ CPIFC → (↓) ↑ real exchange rate (DC/FC)
(↓) ↑ CPIDC → (↑) ↓ real exchange rate
(↓) ↑ nominal exchange rate → (↓) ↑ real exchange rate
Spot exchange rate: The exchange rate for immediate delivery
Forward exchange rate: The exchange rate for delivery sometime in future.
LOS 21.b
Foreign Exchange Market
LOS 21.c
i) Direct Quote:
Base Currency: The currency which is represented by
one unit
Price currency: The currency represented by more or
ii) Indirect Quote: less than one unit is called price currency.
Indirect Quote =
! "# $% #
LOS 21.d
LOS 21.e
Cross rate:
It’s the exchange rate between two
currencies derived from a third
common currency.
£ ;<= £
= ×
9:! 9:! ;<=
LOS 21.h
Countries That Don’t Have Their Own Currency: Countries That Have Their Own Currency:
i. Use currency of another country as its own (formal i. Currency board arrangement
dollarization). ii. Conventional fixed peg arrangement
ii. Use of a common currency (Participating in a iii. Crawling peg (active and passive)
monetary union) iv. Management of fixed exchange rate with crawling
bands
v. Managed floating exchange rates.
vi. Independently floating rates
LOS 21.j
LOS 21.j
Elasticities Approach:
^_`abcd
] =
^_`abcd + fg`abcd
fg`abcd
]< =
^_`abcd + fg`abcd
Marshall – Lerner condition where depreciation of DC → ↓ Trade deficit (X –
M)
WX EX + WI (EI – 1) >0
The J-Curve:
Short-term ↑ in deficit followed by ↓ when Marshall-Lerner condition is met is
referred to as the J-Curve
Absorption Approach:
Focuses on capital account & can be represented by:
BT = Y – E
Where,
BT: Balance of Trade
Y: National Income
E: Domestic expenditure