The Role of the Exchange Rate in the Economy

The exchange rate provides a key macroeconomic linkage between the domestic economy and the rest of the world that takes place through the goods and asset markets. In the goods market, the exchange rate establishes linkages between domestic and foreign prices through the relationship (2.1)<math display='block'> <mrow> <mi>P</mi><mo>=</mo><mi>&#x03B1;</mi><mo>+</mo><mi>&#x03B2;</mi><mi>E</mi><mi>P</mi><mo>*</mo> </mrow> </math> $$ P = \alpha + \beta EP* $$ where P is domestic prices, P* is foreign prices and the exchange rate is expressed as the domestic currency price of one unit of the foreign currency. The parameters that reflect transaction costs and other market imperfections are α and β. This is a linear relationship between domestic prices and foreign prices expressed in domestic currency terms. It shows that the higher the exchange rate, other things being equal, the higher the price of foreign goods in the home country (δP/δE>0). The same relationship can be seen in Figure 2.1, which depicts P as a function of P*. As the exchange rate rises (the domestic currency depreciates) the line P = α + βEP* rotates upwards, leading to higher P for the same level of P*. This happens either directly (because the domestic price of imported goods rises) or indirectly (because domestic firms can afford to raise their prices when competitors’ prices rise). Some of the effect is transmitted through the labour market, as workers may demand wage increases when higher import prices raise the cost of living. Governments that are aware of this connection would prefer to stop depreciation but if they do so in the face of domestic inflation they risk a loss in competitiveness.