In international debates about monetary policy spillovers and international trade competition, the main topic is the relative value of a country’s currency. The popular discussion about how fluctuations in exchange rates impact trade and inflation is often simplistic. As the cost of imported goods rises, an exchange rate depreciation can be interpreted as inflationary. It is also perceived as improving a country’s trade balance by increasing its competitiveness. It is difficult to see how inflation may differ in different countries.

The International Price System (IPS), has many implications for monetary policies and international spillovers. It has positive implications for inflation stabilization. The IPS suggests that the U.S. is less concerned about inflation stabilization due to fluctuations in exchange rates (that are caused by external shocks), than countries like Turkey. 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. You can see how the international market affects prices of coins such as Lebanese Lira Rate.

One concern expressed by the U.S. is the impact of an appreciation in the dollar on inflation as it considers raising its interest rates. The IPS says that while moderate dollar appreciations will not cause major inflationary concerns in the U.S., they could be a source of important inflationary concerns in a country such as Turkey, whose currency is depreciating relative to the dollar.

The exchange channel for the U.S. is much less supportive of monetary policy for Turkey than for dampening or raising inflation to meet targets through contractionary (expansionary) monetary policies.

The nominal exchange rate refers to the currency exchange rate. The nominal exchange rate between the dollar (dollar) and the lira (1600), means that one dollar will buy 1600 lire. Exchange rates are always expressed in terms of how much foreign currency can be bought for one unit of domestic currency. The nominal exchange rate is determined by the amount of foreign currency that can buy for one unit of domestic money.

The real exchange rate can be a little more complex than the nominal rate. The nominal exchange rate indicates how much foreign currency can exchanged for one unit of domestic currency. However, the real exchange rates tells you how much goods and services can be exchanged in the domestic country for goods and services from a foreign country. The following equation shows the real exchange rate: real rate = (nominal currency rate X domestic prices) / (foreign exchange rate).

Let’s suppose that we want the real wine exchange rate between the USA and Italy. We know that the nominal currency between these two countries is 1600 lire per dollar. We also know that wine in Italy costs 3000 lire and wine in the US $6. In this example, we will compare similar types of wine. We will use the following equation to calculate the real exchange rates of real currency: (nominal exchange price X domestic price) /(foreign price). Substituting the numbers above results in real exchange rate = (1600X $6) /3000lira =3.2 bottles of Italian wine for each bottle of American wine.

We can use both the nominal and real exchange rates to determine the relative cost of living between two countries. A high nominal rate can give the illusion that one unit of currency can be used to purchase many foreign goods. However, this is not true.

The Real Exchange Rate and Net Exports

The net exports of a country and its real exchange rate are closely linked. If the real exchange rate in a country is high, then the relative prices of goods at home and abroad are higher. Import is more likely in this situation because foreign goods are less expensive than domestic goods in real terms. When the real exchange rate rises, net exports fall as imports increase. Or, net exports will increase when exports rise when the real rate is lower.

According to the International Fisher Effect (IFE), the difference in nominal interest rates between two countries is directly proportional with the exchange rate of their currencies at any particular time. The theory was developed by Irving Fisher, an American economist.

The International Fisher Effect uses current and future nominal interest rates to forecast spot and future currency movements. To predict and understand changes in the exchange rate, the IFE is different from other methods that rely on inflation.

How the International Fisher Effect was conceptualized

The International Fisher Effect theory is based on the fact that interest rate are independent from other monetary variables. They provide strong indicators of the country’s currency performance. Fisher claims that inflation changes do not affect real interest rates because the real rate is the nominal rate less inflation.

This theory states that countries with lower interest rates will experience lower levels of inflation. This will result in a higher real value for their currency relative to other currencies. Inflation will rise if interest rates are high. This will cause the currency to depreciate.

By Manali