When it comes to international spillovers of monetary policies and international trade competability, the central issue is the relative price of a currency. However, it is not easy to understand how exchange rate fluctuations affect inflation and trade. A depreciation in exchange rates is seen as an inflationary phenomenon when imported goods cost more. This is perceived as a positive for a country’s trade balance, as it is perceived as being more competitive. The systemic understanding of why some countries are more sensitive to fluctuations in exchange rates is missing.

The International Price System, or IPS, has many implications both for monetary and international policy. First, it has positive implications on inflation stabilization. The IPS indicates that U.S. inflation stabilization is more important than for countries such as Turkey due to currency fluctuations (that can arise from external shocks). Using input-output tables to measure the import content of consumer goods expenditure5 I estimate the direct impact of a 10% dollar depreciation to cumulatively raise U.S. CPI inflation overtwoyearsby0.4-0.7percentagepoints.6 Ontheotherhanda10%depreciationoftheTurkish Lira will raise cumulative inflation by 1.65-2.03 percentage points. Check out how international markets affect the prices of currencies like USD LBP lira rate.

The impact of dollar appreciation on inflation is a concern that the U.S. often raises as they consider raising interest rates. The IPS suggests that moderate dollar appreciations won’t cause significant disinflationary concerns to the U.S. but will raise important inflationary worries for countries like Turkey, whose currency has been declining relative to the US dollar.

On the other hand, the U.S. exchange channel provides less support for lowering (or increasing) inflation to meet target targets via contractionary or expansionary monetary policy than it does for Turkey.

The nominal exchange rates is the rate at currency can be exchanged. One dollar will cost 1600 lire if the nominal exchange rates between the dollar, the lira and the dollar is 1600 Exchange rates are always shown in terms the amount of foreign currency you can buy for one unit domestic currency. We determine the nominal exchange rates by identifying how much foreign currency can be bought for one unit.

The real rate of exchange is more complex than the nominal. The nominal exchange rate shows how much foreign currency is available for each unit of domestic currency. But the real exchange rate tells us how much domestic goods and service can be exchanged to foreign goods and/or services. The following equation represents the real exchange rates: real exchangerate = (nominal rate X domestic) /(foreign).

Let’s assume that we are trying to find the true exchange rate for wine between Italy and the US. The nominal exchange rate between these two countries, 1600 lire per $1, is known. We also know the prices of wine in Italy are 3000 lire, and in the US it is $6. This is a comparison of equivalent wine types. We begin by calculating the real exchange rate for real exchange = (nominal rate X domestic) / (foreign). Substituting these numbers gives us the real exchange rate = (1600x $6) / 3000 lire = 3.2 bottles Italian wine per bottle American wine.

The real and nominal exchange rates can be used to calculate the relative cost-of-living in each country. Although a high nominal currency rate might give the impression that a unit can purchase many foreign goods with it, it is only a high real rate that supports this belief.

Net Exports and Real Exchange Rate

There is a significant relationship between net exports, and the country’s real exchange rate. The relative price of goods in the home country is more expensive than those abroad when the real currency rate is high. This is because import is more probable as foreign goods are often cheaper in real terms than domestic goods. If the real rate is high, net imports will decrease while imports rise. The reverse is true: net exports can increase with rising exports if the real exchange rate falls.

The International Fisher Effect (IFE), states that the difference in nominal interest rates of two countries is directly proportional in relation to changes in their currencies during any given time. Irving Fisher, a U.S. economics professor, came up with the theory.

The International Fisher Effect is based upon current and future nominal rates and is used to predict future and spot currency movements. In contrast to other methods which use inflation, the IFE attempts to predict and understand exchange rate movements.

How the International Fisher Effect came to be Conceptualized

The International Fisher Effect theory was developed on the assumption that interest rates are independent monetary variables. This gives a strong indicator of the performance of a country’s currency. Fisher states that changes in inflation don’t affect real interest rates since the real rate is simply the nominal rate plus inflation.

According to this theory, a country with lower rates of interest will experience lower inflation levels. This will lead to an increase in real currency value relative to another country. High interest rates will lead to higher inflation levels, which will cause the currency’s depreciation.

By Manali