ECON30005 · Money and Banking
Exchange Rates and the International Financial System
Week 10 covers exchange-rate determination and the international monetary system. It distinguishes nominal from real exchange rates and shows, via purchasing power parity, why domestic prices rising faster than foreign prices can offset a nominal depreciation. It develops the policy trilemma — a country cannot simultaneously have a fixed exchange rate, free capital mobility and independent monetary policy — and covers fixed versus floating regimes and FX intervention. Expect true/false on PPP and the trilemma, short essays on regimes, and a real-versus-nominal exchange-rate calculation.
What this chapter covers
- 01Nominal exchange rate (foreign currency per unit of domestic): a rise is appreciation, a fall depreciation; the trade-weighted index
- 02Real exchange rate e_R = e·P/P* — the relative price of domestic goods; a rise reduces exports and stimulates imports
- 03Purchasing power parity: the law of one price, e = P*/P, and in changes %Δe_R = %Δe + π − π*
- 04Why a nominal depreciation need not be a real depreciation if domestic inflation outpaces foreign inflation
- 05Determinants of exchange rates: long run (relative prices, productivity) and short run (relative expected returns, interest rates)
- 06Exchange-rate regimes: fixed, floating and managed float; the gold standard and Bretton Woods
- 07The policy trilemma (impossible trinity): choose two of fixed rate, free capital mobility, independent monetary policy
- 08FX intervention and sterilisation; the exchange-rate channel of monetary policy
Real versus nominal depreciation under PPP
- +1Set up the identity. The real exchange rate is e_R = e·P/P*, so in growth rates %Δe_R = %Δe + π − π*, where π is domestic inflation and π* foreign inflation.
- +1Read off the terms. A 6% nominal depreciation means the nominal rate falls: %Δe = −6%. Domestic inflation π = 12% and foreign inflation π* = 2%.
- +1Compute: %Δe_R = −6 + 12 − 2 = +4%. The real exchange rate rises 4% — a real appreciation, even though the currency depreciated in nominal terms.
- +1Interpret: domestic prices rose 10 percentage points faster than foreign prices, more than offsetting the 6% nominal fall, so domestic goods became relatively more expensive. Competitiveness worsened despite the nominal depreciation — a nominal depreciation is not the same as a real depreciation.
Key terms
- Nominal exchange rate
- The rate at which one currency exchanges for another. Under the foreign-currency-per-domestic convention, a rise is a domestic appreciation and a fall a depreciation; the trade-weighted index measures it against a basket of partners.
- Real exchange rate
- e_R = e·P/P*, the price of domestic goods relative to foreign goods in a common currency. A rise (real appreciation) makes domestic goods relatively dearer, tending to reduce exports and raise imports.
- Purchasing power parity (PPP)
- The proposition, built on the law of one price, that e = P*/P so the real exchange rate is constant. In changes, %Δe_R = %Δe + π − π*; PPP explains long-run exchange-rate movements better than short-run ones.
- Policy trilemma (impossible trinity)
- The constraint that a country can have only two of a fixed exchange rate, free capital mobility and independent monetary policy. Fixing the rate with open capital markets forces the domestic rate to track the anchor country's, sacrificing independence.
- Sterilised intervention
- FX intervention whose money-supply effect is offset by domestic open-market operations, so buying or selling the domestic currency does not change the money supply. Inflation-targeting floaters typically sterilise.
- Bretton Woods system
- The 1944-1971 regime of currencies pegged to the US dollar, itself convertible to gold at $35/oz for official holders; it established the IMF and World Bank and collapsed in 1971 when the US suspended gold convertibility.
Exchange Rates and the International Financial System FAQ
How can a currency depreciate in nominal terms but appreciate in real terms?
Because the real exchange rate also depends on relative prices: e_R = e·P/P*, so %Δe_R = %Δe + π − π*. If domestic inflation exceeds foreign inflation by more than the nominal depreciation, the real exchange rate rises even though the nominal rate fell. For example a 6% nominal depreciation with domestic inflation 10 points above foreign inflation gives a 4% real appreciation. The lesson is that competitiveness depends on the real, not the nominal, exchange rate.
What exactly is the policy trilemma?
It is the impossibility of having all three of a fixed exchange rate, free capital mobility and independent monetary policy at once — you can pick only two. If capital is free and the rate is fixed, any gap between the domestic and anchor interest rates triggers capital flows that pressure the peg, so to hold the peg the central bank must set its rate equal to the anchor's, losing monetary independence. The three feasible corners are: float (free capital + independence), a hard peg (free capital + fixed rate, no independence), or capital controls (fixed rate + independence).
What is the difference between sterilised and unsterilised FX intervention?
Unsterilised intervention lets the money supply change: buying domestic currency with reserves withdraws money from circulation, selling it adds money. Sterilised intervention offsets that effect with a domestic open-market operation, so the intervention moves the exchange rate without moving the money supply. Central banks running inflation targets under floating or managed-float regimes usually sterilise, because they do not want FX operations to disturb their domestic monetary stance.
Can AI help me with exchange rates in ECON30005?
Yes. Sia can compute real-versus-nominal exchange-rate changes under PPP, reason through the trilemma edge by edge, and explain FX intervention and sterilisation. Use it to rehearse the identities and the regime logic; it does not sit graded assessment for you, and you should confirm the rules on Canvas.
Exam move
Nail the two workhorses of this week: the real exchange rate e_R = e·P/P* (in changes %Δe_R = %Δe + π − π*) and the policy trilemma. Practise the PPP calculation until the sign convention is automatic, and always state whether the result is a real appreciation or depreciation and what it means for competitiveness — the 'nominal depreciation is not a real depreciation' point is a favourite true/false. For the trilemma, be able to argue each of the three edges and map real countries to the corners (float, hard peg, capital controls). Keep a short timeline of the international system (gold standard → Bretton Woods → floating) and the mechanics of sterilised versus unsterilised intervention. This week sets up the twin-crisis chapter, where a fixed rate plus foreign-currency debt turns a depreciation into a banking crisis. Confirm the exam structure on Canvas.
Working through Exchange Rates and the International Financial System in ECON30005? Sia is AskSia’s AI Economics tutor — ask any ECON30005 Exchange Rates and the International Financial System question and get a clear, step-by-step explanation grounded in how ECON30005 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
