Exchange Rate Economics: Theories and Evidence

2 Introduction
Although the textbook exposition of,say,the operation of monetary and fiscal
policy in an open economy often portrays this in the context of the polar cases
of fixed versus floating exchange rates,there are a large range of intermediate
regimes between the extremes of fully flexible and rigidly fixed exchange rates and
these are considered in Section 1.9,along with some practical issues relating to the
measurement of exchange rate regimes.
The advantages and disadvantages of fixed versus flexible exchange rates are
considered in Section 1.10,along with some discussion of the empirical evidence
on the historical performance of the two kinds of regimes. In Section 1.11 we
have a discussion of the determinants of exchange rate regimes while Section 1.12
focusses on currency invoicing practices.
1.1 Exchange rate definitions
There are two types of nominal exchange rates used extensively throughout
this book,namely,the spot and forward exchange rate. The bilateral spot
exchange rate, S,is the rate at which foreign exchange can be bought and sold
for immediate delivery,conventionally 1 or 2 days. The bilateral forward rate,
F ,is that rate negotiated today (time t) at which foreign exchange can be bought
and sold for delivery some time in the future (when a variable appears without a
time subscript it is implicitly assumed that it is a period-t variable). The most popularly
traded forward contract has a maturity of 90 days and contracts beyond
1 year are relatively scarce. Forward contracts are generally negotiated between
an individual – for example,a private customer or commercial organisation – and
a bank and the individual has to take delivery of the contract on the specified date.
Futures contracts,which are also rates negotiated in the current period for delivery
in the future,differ from forward contracts in that they are bought and sold on
an organised exchange and the individual holding the contract does not need to
take delivery of the underlying asset (it can be bought or sold on the exchange
before the delivery date on the exchange). Futures rates are hardly addressed in
this book. In general,throughout the book we define nominal exchange rates as
home currency price of a unit of foreign exchange. This definition has been chosen
since it is the most widely used in the exchange rate literature. It implies that an
increase in the exchange rate (a rise in the price of foreign currency) represents a
depreciation and a decrease in the exchange rate represents an appreciation. As
we shall see,when considering effective exchange rates (both real and nominal),
and sometimes for real bilateral rates,the convention is the opposite – a rise in an
effective exchange rate represents an appreciation. In general,lower case letters
denote the natural logarithm of a variable and so s = ln S and f = ln F .
These measures of the exchange rate are nominal. A real exchange rate is
measured by adjusting the nominal exchange rate by relative prices. For example,
the real exchange rate, Q ,derived from adjusting the bilateral nominal exchange
rate is:
Q = SP ∗
P ,