David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

Summary
This figure is helpful in thinking about implications
of foreign indebtedness in the aftermath of
the financial crisis. Because of greater risk-taking
by financial institutions in London, the UK had
above-average exposure to the financial crash.
The UK government's debts increased sharply
as it bailed out failing financial institutions.
Figure 24.5 implies that, to the extent that interest
payments are made to foreigners such as Chinese
investors, we should expect the real sterling
exchange rate permanently to depreciate as
a result of the crash. To service permanent
interest payments to the Chinese, the UK has to
run a larger trade surplus than before, which
requires greater competitiveness achieved by
a depreciated exchange rate.
What about countries such as Greece within the
eurozone. With much higher debts than previously
recognized, it also requires a real depreciation,
for the same reason as the UK. This could be
achieved by a nominal depreciation of the euro.
But the eurozone also includes some much
healthier economies that do not require such a
depreciation. The textbook solution therefore
includes a reduction of domestic prices in Greece
in order to improve its competitiveness by
depreciating its real exchange rate.
CA
CA (creditor)
CA (debtor)
RER
The current account CA is net exports NX plus net interest on
foreign assets. For current account balance, a debtor country
needs a low real exchange rate R0 to be competitive and have
a sufficient trade surplus to pay interest on its foreign debts.
A creditor country has a high real exchange rate R1 to reduce
competitiveness and run a trade deficit, financed by interest
earned on foreign assets.
Figure 24.5
Foreign assets and the real exchange rate
In practice, this requires that Greece undertake a greater reduction in aggregate demand than other
countries. Thus a fiscal contraction not merely deals with its budget deficit, but also puts downward
pressure on prices and wages in Greece. With sluggish wage adjustment in the Greek labour market, this
is a recipe for high unemployment while adjustment is taking place. Whether the Greek government is
strong enough to administer the medicine is something that bond markets are watching with concern.
This completes our analysis of the long-run equilibrium exchange rate, compatible with both internal and
external balance. In the long run, it is thus the current account of the balance of payments that affects the
exchange rate. The financial account gets into the story only to the extent that the cumulation of past
capital flows is what determines the current stock of net foreign assets.
In the short run, the story is very different. Countries can run large current account surpluses and deficits.
Short-run changes in the exchange rate then have much more to do with the financial account. The role of
capital flows is one theme of the next chapter. The other themes are how the economy adjusts to temporary
shocks and returns to internal and external balance, whether macroeconomic policy can ease this adjustment
and how choice of exchange rate regime affects these issues.
Summary
• The exchange rate is the number of units of foreign currency that exchange for a unit of the domestic
currency. A fall (rise) in the exchange rate is called depreciation (appreciation).
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