The exchange rate policy refers to the manner in which a country manages its currency in respect to foreign currencies and the foreign exchange market. The exchange rate is the rate at which the domestic currency can be converted into a foreign currency. In turn, this affects the costs of domestic production and finance relative to foreign products and capital. In formulating exchange rate policy, a balance must be found between several differing, and sometimes conflicting, objectives. In particular, the use of the exchange rate to promote the competitiveness of domestically-produced goods must be considered alongside the implication for the international purchasing power of the currency and, in particular, the impact of changes in the exchange rate on domestic inflation.
- Exchange rate: the price of one currency in terms of another.
- Nominal exchange rate: the actual exchange rate at which currencies are exchanged on the foreign exchange market.
- Real exchange rate: the nominal exchange rate adjusted for inflation differentials.
- Floating exchange rate: an exchange rate which is solely determined by the forces of demand for and supply of domestic currency with no intervention by the monetary authorities.
- Pegged exchange rate: an exchange rate system in which the value of the domestic currency is set relative to another currency or a basket (combination) of currencies; changes to the peg are made through discrete (i.e., step-like) adjustments.
- Managed float: an exchange rate system where the authorities have the discretion to intervene in the foreign exchange markets to guide the value of the domestic currency.
- Crawling peg/band mechanism: an exchange rate system where the value of the domestic currency is adjusted on a regular basis according to a pre-determined formula that takes account of, for example, actual or expected inflation differentials. If the rate of adjustment (or crawl) is determined precisely, then it is crawling peg; while, if some fluctuation allowed then it is a crawling band.
- Nominal effective exchange rate (NEER): a weighted average of bilateral nominal exchange rates, with weights typically based on the trade shares.
- Real effective exchange rate (REER): the NEER adjusted for inflation differentials.
- Exchange rate appreciation: a decrease in the domestic currency price of the foreign currency due to market forces or in the normal course of business.
- Exchange rate depreciation: an increase in the domestic currency price of the foreign currency due to market forces or in the normal course of business.
- Exchange rate devaluation: in a fixed exchange rate regime, a policy decision to make a discrete reduction in the value of the domestic currency.
- Exchange rate revaluation: in a fixed exchange rate regime, a policy decision to make a discrete increase in the value of the domestic currency.
- Special Drawing Rights (SDR): the official unit of account (currency) of the International Monetary Fund, (IMF). It is comprised of a weighted combination of the US dollar, British pound, euro and Japanese yen with the composition reviewed periodically, most recently in November 2005.
- Dutch disease: a situation where large inflows of foreign exchange cause the real exchange rate to appreciate resulting in some sectors of the economy becoming uncompetitive. A typical example is the discovery and subsequent exploitation of mineral resources: the term ‘Dutch’ refers to the impact of the discovery of natural gas had on the competitiveness of manufacturing in the Netherlands.
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