An exchange rate is the price of one currency expressed in terms of another. An exchange rate system is the way in which the exchange rate is determined. These come in three types. They are:
Fixed – this is an exchange rate system where one currency is fixed in value against another. It involves the government working to keep the parity via intervention on the currency markets. These give certainty but can cost vast sums of foreign exchange from national reserves.
Floating – this is an exchange rate which accepts that market forces will determine rates based on how they view a country’s trade performance and its economic and political stability. These systems cost less to maintain but can result in vast swings and changes in currency values. This can seriously affect trade performance and confidence.
Managed or dirty float – which is where the rate is floating but between upper and lower limits that the domestic government keeps it to. It brings more stability but at less cost to the national reserves.
Appreciation – this describes an upward movement in a freely floating exchange rate. This may occur day by day or perhaps even minute by minute.
Revaluation – this also describes an upward movement in an exchange rate, but in a fixed exchange rate system. This will be a very infrequent event (if ever) and means the government has deliberately changed the fixed value of the exchange rate upwards.
Depreciation – this describes a downward movement in a floating exchange rate.
Devaluation – this means that the government has changed the fixed rate of a fixed exchange rate downwards.
The Marshall-Lerner condition looks at the overall impact of a depreciation on the current account of the balance of payments. This will be the sum of the effects we identified above on imports and exports. The condition states that the current account will improve after a depreciation if the sum of the price elasticities of demand for imports and exports is greater than 1.
J-Curve – Evidence around the world suggests that the Marshall-Lerner condition does not hold in the short run, but does in the medium to long run. This is because in the short run, there will be few extra exports sold when prices fall – people overseas do not react immediately and so export demand will take time to change. However, extra money will have to be paid for imports immediately and so the current account will tend to deteriorate. In the medium term however, the lower export prices will start to lead to an increase in demand for them and so the current account will start to improve. The export elasticity of demand is therefore low in the short run, but will be higher in the long run.