Exchange Rates – Nominal vs Real, PPP, and Policy
Every cross-border deal translates prices across currencies. A factory in Mexico quotes in pesos while a buyer in Sweden pays in kronor. That translation uses an exchange rate. Treat it as the relative price of two monies. Once you see exchange rates this way, you can read trade headlines without panic, plan pricing for exports, and explain why a country’s tourism booms after a depreciation or why imported fuel gets pricey during a slide. This chapter builds the model from the ground up and then puts it to work in real decisions. We connect nominal and real exchange rates, regimes from free float to hard pegs, the balance of payments, purchasing power parity, interest parity, pass-through to inflation, the J-curve, central bank intervention, the trilemma, sudden stops, and the corporate playbook for quoting, billing, and hedging. No mystique. Just the moving parts and how to use them.
The basic language – nominal, real, appreciation, depreciation
An exchange rate can be quoted directly as home currency per unit of foreign currency or indirectly as foreign currency per unit of home currency. Be explicit about your convention or meetings go sideways fast. If EUR/SEK rises, one euro buys more kronor, which means the krona depreciates against the euro and the euro appreciates against the krona. That is the nominal move.
The real exchange rate adjusts the nominal rate for relative price levels. It shows the true price of a typical basket of goods at home versus abroad once you account for inflation. Real appreciation means your basket got pricier relative to others after adjusting for inflation. Real depreciation means your basket got cheaper. For trade and tourism, the real move matters more than the nominal headline because it tells you about competitiveness. If your nominal rate is flat but domestic prices rise faster than abroad, you still real-appreciated, and exporters feel the squeeze.
Why exchange rates move at all
Rates move because supply and demand for currencies move. Households buy imports. Firms pay suppliers or receive export revenue. Travelers swap cash. Portfolio managers shift across markets. Central banks set short rates and sometimes step into foreign exchange markets. Expectations pull a lot of weight. If markets expect a central bank to raise its policy rate relative to peers, demand for that currency rises today. If investors fear a fiscal blowout or sustained inflation, demand can fall. News lands, expectations shift, order books adjust, and the rate moves.
Under the hood, three anchors keep the analysis honest. Over short windows, interest rate parity links short rates and currency forward prices. Over long horizons, purchasing power parity ties trend moves to relative inflation. Across all horizons, the balance of payments must balance. Every current-account gap is offset by financial flows and changes in reserves. Those identities are not fancy. They are the accounting rails the train runs on.
Exchange-rate regimes: who sets what and how rigid is the promise
Countries choose how much to let their currency move. A free float lets the market set the price with the central bank focused on domestic goals, usually a stated inflation target. A managed float or dirty float keeps a flexible rate but allows the central bank to lean against disorderly moves. A peg fixes the currency to another one, often the US dollar or the euro. A crawling peg adjusts in small steps. A currency board promises one-to-one convertibility with hard balance-sheet rules. Some countries adopt another country’s currency outright.
Each choice has trade-offs. A float gives monetary policy independence and lets the exchange rate absorb shocks. A peg imports the anchor country’s policy and gives price stability if you can defend it. The impossible trinity or trilemma says you cannot have all three of these at once: a fixed rate, free capital movement, and an independent monetary policy. Pick two. If you fix the rate and keep borders open to capital, your policy must follow the anchor. If you want policy freedom with open capital flows, you need a flexible rate. If you insist on a fixed rate and a distinct policy, you must control capital flows.
The balance of payments: the ledger that always nets to zero
Every country keeps two big books. The current account records trade in goods and services, net income from abroad, and transfers such as remittances. The financial account records cross-border purchases of assets and liabilities along with changes in official reserves. Add them together with a small errors line and you get zero. If a country runs a current-account deficit, it must attract foreign financing or draw down reserves. If it runs a surplus, it accumulates foreign assets or sells fewer of its own.
Treat this as a cash-flow statement for the nation. A deficit can be fine if foreign capital is funding productive projects that raise future output. It can be risky if short-term flows fund consumption while reserves are thin. A surplus can be healthy if it reflects high saving channeled into useful foreign assets. It can also reflect weak domestic demand that suppresses imports. The numbers do not judge values. They describe flows. Your job is to read the mix and the maturity profile that sit behind them.
Purchasing power parity: the long-run gravity
Purchasing power parity or PPP states that identical baskets should cost the same when priced in a common currency once you ignore transport costs and trade barriers. Absolute PPP rarely holds exactly because baskets differ and services are local. Relative PPP works better. It says the exchange rate tends to adjust over time to offset inflation differentials. If your prices run two points above your trading partner for years, expect your currency to drift weaker in nominal terms. PPP is not a week-to-week signal. It is a long-run compass that keeps forecasts from drifting into fantasy.
A common operational tool here is the real effective exchange rate or REER. It is the trade-weighted real value of a currency against a basket of partners. If your REER climbs, you gained real value against partners on average. If it falls, you lost. Manufacturers, tourism boards, and central banks watch this measure because it captures the multi-partner reality of modern trade.
Interest rate parity: the short-run constraint
Covered interest parity says that once you use a forward contract to lock the future exchange rate, there is no arbitrage profit from borrowing in one currency and lending in another. The forward rate must equal the spot rate adjusted by the interest-rate gap. If not, traders step in until it does. Uncovered interest parity drops the hedge and says the expected change in the spot rate equals the interest-rate gap. This second relation is not an iron law because risk and preferences matter, but it is a useful way to frame discussion. Raise your short rate relative to peers and your currency often strengthens today because the expected path of policy is now higher.
These parity conditions matter to real companies. A firm quoting three months ahead needs to decide whether to bill in home currency and let the buyer take the risk, bill in the buyer’s currency and hedge in forwards, or index the price with a clause that splits currency risk. The right answer depends on bargaining power, margins, and market practice in that industry.
Exchange rates and inflation: pass-through, pricing, and persistence
A depreciation raises the local currency price of imported goods. The size and speed of this pass-through depend on market structure, invoicing currency, and how often prices are changed. Sectors with many substitutes can resist full pass-through because sellers fear losing share. Sectors with standard pricing in a dominant currency tend to transmit changes faster. If a country prices most imports in dollars, a local depreciation against the dollar often shows up quickly in fuel and food. If pricing is local-currency dominated, the effect is slower.
Pass-through also depends on expectations. If people believe the central bank will keep inflation near target, firms are less likely to pre-emptively raise prices by large amounts after a currency move. If expectations slip, price setters may embed more of the shock. This is why communication and credibility matter. A clear target and steady actions reduce the chance that a currency swing mutates into a broad inflation drift.
The J-curve and the Marshall-Lerner condition
Currency changes do not fix trade balances overnight. Contracts are sticky. Quantities take time to respond. After a depreciation, the trade balance often worsens at first because import prices jump in local currency while volumes have not yet fallen. Over time, if demand elasticities for exports and imports are strong enough, export volumes rise and import volumes fall, and the balance improves. That time path is the J-curve. The condition for long-run improvement is the Marshall-Lerner rule, which says the sum of export and import demand elasticities must exceed one. If buyers barely respond to price, the balance may not improve even with a weaker currency.
Exchange rates and growth: the tradable engine and Dutch disease
A sustained real depreciation can boost the tradable sector by making goods cheaper abroad and imported rivals dearer at home. Firms hire, order books fill, and clusters take shape. The risk on the other side is Dutch disease, where a boom in resource exports or capital inflows drives real appreciation that crowds out manufacturing or other tradables. Wages drift up, nontradable services expand, and when the boom fades the economy finds itself hollowed out. Policy can cushion this by saving resource revenue in a sovereign fund, by keeping fiscal policy steady through cycles, and by investing in productivity so the nontradable sector produces more with fewer price pressures.
Central bank intervention, reserves, and sterilization
Even floaters sometimes intervene when moves are disorderly or when liquidity dries up. Buying domestic currency with foreign reserves can lean against a slide. Selling domestic currency can temper a surge. Small, clear operations often work better than grand gestures. If the central bank intervenes without changing the domestic monetary base, it sterilizes the operation through open market actions. If it does not sterilize, the operation changes domestic liquidity and can move short rates. The credibility of the broader policy framework sets the backdrop. Intervention inside a coherent strategy can smooth volatility. Intervention that fights fundamentals usually burns reserves without changing the trend.
Reserves exist for this reason. They cover imports, reassure markets, and let the central bank provide foreign currency during stress. The right level depends on the openness of the economy, the structure of liabilities, and the scale of potential outflows. Countries with heavy short-term foreign currency debt need deeper buffers than countries with mostly local currency debt and long maturities.
External debt, original sin, and sudden stops
Borrowing in foreign currency exposes a country to balance sheet risk. A depreciation raises the local currency value of that debt while revenue stays local. That squeeze can trigger a sudden stop where external lenders refuse to roll funding and capital flees. The cure is dull and tough. Build local-currency markets over time. Lengthen maturities. Keep fiscal policy credible. Hold reserves sized to plausible outflows. During stress, central banks can use swap lines with peers to ease foreign currency funding and prevent payment gridlock. Firms can reduce exposure by keeping foreign debt aligned with foreign revenue so cash inflows match outflows.
Trade invoicing, dominant currencies, and pricing-to-market
Many traded goods and commodities are invoiced in a few dominant currencies even when the buyer and seller are from third countries. This dominant currency pricing slows pass-through and shapes how exchange rate moves filter into local prices. It also means that depreciation against the invoicing currency bites faster than depreciation against a partner who does not set the invoice. Large exporters often price-to-market, adjusting markups by destination to keep shelf prices in line with local conditions. That tactic dampens the volume response to currency swings because the exporter absorbs part of the move into margins. For managers, the lesson is not abstract. Pick your billing currency on purpose. It changes who carries the currency risk and how volumes respond.
Exchange rates and interest rates – the policy handshake
Monetary policy and exchange rates are intertwined. Raise your policy rate relative to peers and, all else equal, you support your currency through the expectations and interest parity channels. Cut your policy rate and you may weaken it. But the world is messier. If you hike because of a homegrown inflation problem and credibility is fragile, the market may see a policy mistake and push the currency the other way. If you cut during a global panic while peers cut more, your currency can strengthen. Read the relative move and the context, not just the direction.
Fiscal choices matter too. A boom-time deficit that overheats demand can trigger real appreciation through higher domestic prices or higher long yields that attract capital. A credible multi-year consolidation can lower risk premiums, support the currency, and stabilize debt service. Policy mix is not a slogan. It is two levers that either coordinate or fight each other.
Tourism, remittances, and the services channel
Exchange rates touch lives through tourism and remittances. A weaker currency draws visitors who find hotels, food, and transport cheaper in their money. That surge supports local jobs and spreads income to regions that do not export goods. Remittances sent home become more valuable in local currency after a depreciation, which can cushion households when import prices rise. The opposite holds after an appreciation. Cities that live on visitors learn these mechanics quickly. Pricing, staffing, and promotions shift with the rate.
Services trade is broadening. Software subscriptions, consulting, creative work, and support centers cross borders digitally. For these flows, exchange rates still matter, but barriers shift from tariffs to data rules and licensing. The winning teams know both playbooks. They can clear customs for physical goods and clear compliance for digital services while quoting in the currency their customers prefer.
Crisis dynamics – overshooting and recovery
Exchange rates can overshoot. Prices and wages change slowly. Financial markets change instantly. A shock that raises domestic interest rates can cause an appreciation that goes beyond the new steady state. Over time, as prices adjust, the currency drifts back. That is the overshooting story in plain words. In reversals, a country with thin reserves and weak balance sheets can see the opposite. The currency slides past fair value, pause points break, and the move feeds on itself until policy or external support draws a line.
Recovery follows a pattern. The central bank stabilizes the payment system. The treasury presents a credible plan that closes funding gaps. External partners may provide backstops. Once expectations re-anchor, the currency lifts off the floor. Firms with foreign revenue and local costs expand. Tourism returns. Imports remain soft while the tradable sector rebuilds. A calm, boring policy mix beats flashy announcements.
How companies operationalize exchange-rate risk
Inside a firm, currency is not a debate topic. It is a daily process. Sales decides quote currency by market. Finance sets a hedge ratio and uses forwards or options to lock margins on known orders. Procurement diversifies suppliers across regions so a move in one currency does not hit every input at once. Treasury staggers debt maturities and aligns foreign currency debt with foreign cash inflows. Pricing teams build exchange-rate clauses for long deals, often with banded adjustments to avoid nickle-and-diming customers for tiny moves. Reporting translates foreign subsidiaries back to group currency with a clear policy so managers are not confused by translation noise. The strongest teams practice these drills before they are needed. The weakest teams prepare a speech after a quarter goes sideways.
Students can simulate this with a simple sheet. Enter a base price, a spot rate, a forward rate, and the share of costs in each currency. Shock the rate by five percent in either direction. Record the margin. Add a line for a forward hedge. The difference between hedged and unhedged margin is not theory. It is payroll.
Case study: an exporter facing a sudden appreciation
A firm that sells machinery abroad prices in euros and reports in krona. The krona appreciates sharply after a central bank surprise. Without changes, the euro price converted to krona would drop, squeezing margin. The sales team raises euro list prices by a small amount in markets with high willingness to pay and holds prices in markets with tougher competition, using price discrimination by region to keep volumes steady. Finance puts on forward hedges for the next two quarters at the new rate to stabilize planning. Procurement accelerates a shift to a supplier who bills in euros to create a natural hedge. Within a quarter, margins stabilize and orders normalize. The appreciation still hurts, but the hit is controlled rather than chaotic.
Case study: a retailer during a depreciation
A retailer imports apparel billed in dollars while sales are in local currency. The currency slides. The next shipment would blow up unit costs if priced the old way. The merchant team responds with three moves. First, it pushes higher-margin accessories and packs that keep basket value up. Second, it reduces exposure to SKUs with tight dollar margins and fills space with local brands whose cost base is domestic. Third, it negotiates with suppliers for temporary cost sharing citing the size of the relationship and the industry practice during shocks. Price tags move up, but not one for one with the currency. Customers see smaller jumps spread across categories. The store protects loyalty while keeping the lights on.
Case study: a tourism rebound after a large depreciation
A country with a big services sector experiences a real depreciation after a terms-of-trade shock. Tourism agencies move quickly. They reprice packages in target markets, work with airlines on seasonal capacity, and cut red tape for digital visas. Hotel occupancy rises. Restaurants hire. Regions far from export hubs feel relief. Import prices remain high so living costs bite, but the external accounts improve as services exports surge. The lesson is tactical. Currency moves create windows. Operators who move first capture the wave.
Common myths that waste meeting time
“A strong currency is always good.” A currency that is strong for the right reasons signals healthy productivity and credible policy. A currency that is strong because of a short-term commodity boom or hot money can damage tradables and set up a fall. Strength without context is not a virtue.
“Devaluation fixes everything.” A weaker currency helps exporters and tourism if they can scale. It hurts households through import prices and can trigger inflation if expectations are shaky. Without follow-through on productivity, the boost fades.
“Central banks can pick any rate they want.” They can choose a regime and influence the rate through policy, but they cannot repeal arithmetic. Reserves are finite. Credibility is earned. If you promise an unsustainable peg while running loose policy and thin buffers, the market will test you.
“Trade balances move one-for-one with the currency.” Elasticities, invoicing, contracts, and the J-curve break the one-for-one story. The direction often matches the textbook. The size and timing rarely do.
A Final Note
State your base currency and be consistent. Know your invoicing currency by product and region. Measure your natural hedge by matching foreign cash inflows and outflows. Use simple hedges for contracted orders rather than guessing the market. Do not anchor on today’s spot. Run plus or minus five percent scenarios and pre-write the pricing and sourcing moves each would trigger. Watch real-time indicators that matter to your category. For importers, that is the pair rate against your billing currency, freight quotes, and competitor prices. For exporters, that is the trade-weighted real rate and inquiry volume from abroad. Keep a calm cadence. Overreacting to noise breaks trust with customers and suppliers.