Real effective exchange rate

The real effective exchange rate measures the value of a currency against a basket of other currencies; it takes into account changes in relative prices and shows what can actually be bought.

Sterling effective exchange rate index.

Nominal exchange rate

The nominal exchange rate measures the current value of a currency against another. For example, in Sept 2014

£1 – $1.61 or $1 = £0.62

Effective exchange rate

The effective exchange rate measures a currency against a basket of other currencies. This is usually trade-weighted. When looking at the effective Sterling exchange rate, we will compare the value of Sterling against our main trading partners – The Euro, the Dollar, the Yen e.t.c and give a weighting depending on how much we trade with that country, e.g. Eurozone 60%. A weighting will be given to different trading countries depending on how significant they are.

The effective exchange rate is good for looking at the overall performance of a currency. For example, the Pound may appreciate against the Dollar – but this may be due to just temporary weakness in the Dollar. However, if the overall effective exchange rate increases, it suggests the Pound is becoming stronger.

Real exchange rate

The real exchange rate measures the value of currencies, taking into account changes in the price level. The real exchange rate shows what you can actually buy. It is the value consumers will actually pay for a good.

RER = E.R *(price level in country A/Price level in country B)

Increase in real exchange rate

  • If a countries real exchange rate is rising, it means its goods are becoming more expensive relative to its competitors.
  • An increase in the real exchange rate means people in a country can get more foreign goods for an equivalent amount of domestic goods.
  • Therefore an increase in the real exchange rate will tend to increase net imports. Foreigners will buy our less expensive exports. It now becomes more attractive to buy imports. This can cause a widening of the current account deficit and lower domestic AD. It will also help reduce inflation.
  • Similarly, a fall in the real exchange rate should increase net exports as domestic goods are more competitive.

(Readers Question: Does an increase in Real Effective Exchange Rate increase or decreases international competitiveness for the country? An increase in the real effective exchange rate will decrease international competitiveness. It means the country has relatively more expensive exports, leading to a fall in net Ex)

Inflation and the exchange rate

If the UK experienced inflation of 10% and the US had inflation of 0%.

We would expect the nominal value of the Pound to fall 10%. In this case, the real exchange rate would stay the same.

Due to inflation, British goods are 10% more expensive, but the depreciation then reduces the prices of British exports to America – so the effective price Americans pay is the same. The number of goods you can buy stays the same.

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UK Devaluation of Sterling 1967

current-account-1960s

In 1967, the UK government of Harold Wilson devalued the Pound from $2.80 to $2.40 (a devaluation of 14%). It was a major political event because the government had tried hard to avoid a devaluation, but felt forced into the decision because of a trade deficit, a weak domestic economy and external pressures from creditors. …

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The effects of an appreciation

An appreciation means an increase in the value of a currency. It means a currency is worth more in terms of foreign currency. An example of an appreciation in the value of the Pound 2009 – 2012 Jan 2009  If £1 = €1.1 June 2012 £1 = €1.27 In this case, we can say there …

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What happens to value of currency during recession?

Readers Question: What will happen to the value of a currency during times of deep recession and high inflation?

There is no hard and fast rule about what will happen to the value of a currency during a deep recession – though, a currency is likely to fall because country becomes a less attractive place to invest. For example, when the great recession started in 2008, the UK experienced a significant depreciation.


The Pound Sterling fell over 25% from 2007 (before the start of the great recession) to July 2009

But the Euro and Dollar were less affected by the great recession.

U.S._Dollar_IndexThe US dollar index (which shows the value of the US dollar against a trade-weighted basket of other currencies, e.g. Euro and Yen) has fluctuated but overall has remained at similar value to the start of the recession.

Note in early 1980, the US went into recession, but during this period the value of the Dollar rose.

It was a similar experience in the UK, in the 1980s, In 1980,  there was a rapid appreciation in Sterling (which was one factor contributing to the recession of 1980/81.)

Economic theory behind the value of a currency in recession

Suppose one country, e.g. the UK, enters a deeper recession than all its other competitors. How might we expect the currency to behave?

Recession and interest rates. If the UK enters a recession, then we would expect UK interest rates to fall compared to other countries. This would make the UK less attractive for investors to save money. Hot money flows are likely to leave the UK and move to countries with higher interest rates. If people move money out of the UK, they will sell Pounds and buy other currencies, causing a fall in the value of Sterling. Therefore, in theory, we might expect a recession to cause a fall in the value of the currency.

Evaluation

1. In a recession, inflation is likely to fall. Lower inflation will help the country become more competitive, and this may increase demand for the currency causing it to rise.

2. Many factors affect the value of a currency. For example, if the UK had a large current account deficit, then we might expect this trade deficit to put downward pressure on the currency. The fall in the value of Sterling in 2008 was partly related to the UK’s trade deficit and lack of competitiveness. However, if a country like Germany entered a recession, they may be less downward pressure on their currency (the Euro) because Germany has a large current account surplus.

Read moreWhat happens to value of currency during recession?

Does a devaluation help the economy?

effect-of-devaluation-flow

A devaluation (depreciation) occurs when the exchange rate falls in value. This causes exports to be cheaper and imports to be more expensive. In theory, it can help increase economic growth, though it may cause inflation.

In theory, a devaluation will cause the following to happen:

  • The price of UK exports will be lower in foreign currencies. This will increase the competitiveness of UK exports and should cause an increase in demand for UK exports.
  • The price of imported goods into the UK will increase. This will reduce our spending on imports and instead we will be more likely to buy domestic goods.
  • The increase in (X-M) should cause an increase in Aggregate Demand (AD), economic growth and cause a reduction in unemployment.
  • The increased competitiveness should cause an improvement in the current account on the balance of payments.

Evaluation

The impact of a devaluation depends on economic circumstances.

  • If a country is suffering from being uncompetitive with high unemployment and low inflation – a devaluation may help considerably.
  • However, in a severely depressed global economy (e.g. 2008-13), a devaluation may be insufficient to restore economic growth.
  • The fall in the value of the Pound (2016) is partly due to concerns over Brexit (British exit from EU). This is causing uncertainty and will likely to reduce investment from export firms. In this situation, the devaluation will probably do little to boost economic growth. However, with inflation near zero, the usual inflationary pressure of devaluation will not be a problem.

effect-of-devaluation-flow

UK Devaluation between 2008 and 2013

Between 2008 and 2013, the Pound experienced a 25-30% devaluation in Sterling, but the UK had only a weak recovery, some cost push inflation and a surprisingly large current account deficit. It seems the depreciation in the pound did little to help the UK economy. This was due to several factors

  • Demand for exports and imports relatively inelastic. UK continued to import more expensive German cars, but export demand also inelastic.
  • Weak Eurozone growth. 2008-13 was a period of low EU growth, therefore more competitive UK exports were insufficient to boost export demand.
  • Fiscal austerity and fall in bank lending were major factors depressing the economy. Therefore, the devaluation was insufficient to compensate for the fall in other components of AD.

Pound Sterling Index

Pound-Sterling-index
Pound Sterling index. The Index measures the value of the Pound Sterling against a basket of major trading countries.

 

Impact of devaluation on economic growth

economic-growth-quarterly

1. Economic growth. In terms of economic growth, the five years after 2007/08 devaluation were relatively low. The devaluation was insufficient to stop the deepest recession for a long time, and the recovery was weak – compared to other recoveries. (see: Comparison of different recessions)

2. Current account deficit. The current account deficit actually got bigger from 2010.

UK-current-account-from-2001

In 2008, the current account deficit was less than 2% of GDP. At the end of 2013, this current account deficit fell to more than 5% of GDP – a very high deficit (more at current account balance of payments) This seems to contradict economic theory – as you would expect a devaluation to improve the current account – not worsen it.

How do we explain the relative failure of devaluation to rebalance the economy in UK 2007-13?

1. Inelastic demand for exports and imports Evidence suggests that demand for UK exports is relatively inelastic. UK exports have become less price competitive as we’ve moved away from low-cost manufacturers to a variety of services and high-tech manufacturing; these goods tend to have relatively few close substitutes. Therefore, even if the price falls, the increase in demand is relatively low. Similarly, demand for imports is relatively inelastic meaning we continue to pay the higher price. (The Marshall-Lerner condition states a devaluation will worsen the current account if PEDx + PEDm >1)

Read moreDoes a devaluation help the economy?

Euro carry trade

A carry trade occurs when an investor borrows in one country (at a low interest rate) and invests this money in another country (which has higher interest rates.) If we assume exchange rates are stable, then this carry trade enables an investor to make a profit – and the profit could be even more if …

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Exchange rate movements – Sterling, Euro and Dollar

The effective exchange rate measures the value of a currency against a basket of other currencies. This exchange rate index is usually trade-weighted to take into account the relative importance of other currencies. When looking at the effective Sterling exchange rate we compare the value of Sterling against our main trading partners – The Euro, …

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Is a strong currency a good thing?

Readers Comment from post: Should the UK join the Eurozone

So now it is 2013. Britain has spent a number of years with it’s interest rate set at just about zero, has entered a triple recession, has lost it’s AAA credit rating and Sterling is only worth €1.15 a drop of over 30% against the Euro.

So for those who still cannot see the wood for the trees and still believe the “anti-euro” propaganda wake up and smell the coffee.

I will put it this way, despite the turmoil the Eurozone has been suffering for the last 5 years, despite it’s inability to drop interest rates to zero to make itself more competitive, despite it’s differing economies and demographics it has risen in value against the UK as a Nation but over 30%. Can you smell the coffee yet?

pound-euro

A while back, I wrote a post – How to measure success in the Eurozone? The main argument of that post is that you can’t measure economic success just from bond yields. In late 2012, the ECB were very happy to see falling bond yields – there was almost a sense that falling bond yields meant the Euro was now doing well, but falling bond yields alone don’t solve unemployment and the wider Eurozone crisis. Sometimes, we judge economic success from only a very limited standpoint, ignoring much more important factors.

One example, is judging the desirability of an economic policy from the strength of a currency.

When you have a large current account deficit, when your economy is in recession, a depreciation is exactly what the economy needs. Having a strong currency, when economic fundamentals don’t support that level just creates further economic misery.

One obvious example that springs to mind is the effort in 1992 to keep the Pound artificially overvalued within the ERM. To keep the Pound at a set level against the D-Mark, we put up interest rates to 15% and caused a severe recession. The strong pound was completely unsuitable for the UK economy, but we persisted with the policy because of a mistaken belief that keeping a ‘strong’ pound was ‘good’.

Another classic mistake was the decision in 1925 to rejoin the gold standard at a level that was unsuitable for the post-war UK economy. The consequence of this decision was deflation, low growth and a rising debt to GDP ratio. (see: UK economy in 1920s)In this case, the strong pound was damaging to the UK economy.

Strength of the Euro

The strength of the Euro has not necessarily increased living standards for people in the Eurozone. For those on the southern periphery of the Eurozone, the strength of the Eurozone has been an important factor in contributing to a prolonged recession and high unemployment.

eu-current-account-deficits

In 2008-11, Eurozone economies faced exceptionally large current account deficits of close to 10% of GDP (and upto 15% in case of Greece). This reflected a fundamental misalignment of the economy. Within the Euro, Portugal, Spain, Greece were uncompetitive, the Euro was too strong making their exports very uncompetitive. In the Eurozone, exporters couldn’t compete leading to lower demand, lower exports, and higher unemployment.

If the UK had been in the Eurozone, we wouldn’t have been able to devalue by 30%. The Pound could now be 30% overvalued. The consequence of this would have been:

  • An even larger current account deficit.
  • Lower domestic demand. The strong Euro would have increased demand for imports, and reduced demand for UK exports.
  • The recession would have been deeper, putting pressure on the government deficit.

Read moreIs a strong currency a good thing?

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