- Define exchange rate system
- List and define the types of exchange rates
- Differentiate between nominal and real exchange rates
- Discuss the crucial role of interest rate policy in the coordination of monetary and exchange rate policies
- Compare real interest rates to nominal interest rates
- Discuss the impact of change in interest rates to exchange rates
- Define closed economy and open economy
- Discuss the exchange rate policies in Pakistan
Define exchange rate system & List and define the types of exchange rates
An exchange-rate regime is the way an authority manages its currency in relation to other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors.
The basic types are a floating exchange rate, where the market dictates movements in the exchange rate; a pegged float, where a central bank keeps the rate from deviating too far from a target band or value; and a fixed exchange rate, which ties the currency to another currency, mostly more widespread currencies such as the U.S. dollar or the euro or a basket of currencies,
Differentiate between nominal and real exchange rates
The nominal exchange rate is the rate at which currency can be exchanged. If the nominal exchange rate between the dollar and the lira is 1600, then one dollar will purchase 1600 lira. Exchange rates are always represented in terms of the amount of foreign currency that can be purchased for one unit of domestic currency. Thus, we determine the nominal exchange rate by identifying the amount of foreign currency that can be purchased for one unit of domestic currency.
The real exchange rate is a bit more complicated than the nominal exchange rate. While the nominal exchange rate tells how much foreign currency can be exchanged for a unit of domestic currency, the real exchange rate tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country. The real exchange rate is represented by the following equation:
real exchange rate = (nominal exchange rate X domestic price) / (foreign price).
Let's say that we want to determine the real exchange rate for wine between the US and Italy. We know that the nominal exchange rate between these countries is 1600 lira per dollar. We also know that the price of wine in Italy is 3000 lira and the price of wine in the US is $6. Remember that we are attempting to compare equivalent types of wine in this example. In this case, we begin with the equation for the real exchange rate of real exchange rate = (nominal exchange rate X domestic price) / (foreign price). Substituting in the numbers from above gives real exchange rate = (1600 X $6) / 3000 lira = 3.2 bottles of Italian wine per bottle of American wine.
By using both the nominal exchange rate and the real exchange rate, we can deduce important information about the relative cost of living in two countries. While a high nominal exchange rate may create the false impression that a unit of domestic currency will be able to purchase many foreign goods, in reality, only a high real exchange rate justifies this assumption.
Net Exports and the Real Exchange Rate
An important relationship exists between net exports and the real exchange rate within a country. When the real exchange rate is high, the relative price of goods at home is higher than the relative price of goods abroad. In this case, import is likely because foreign goods are cheaper, in real terms, than domestic goods. Thus, when the real exchange rate is high, net exports decrease as imports rise. Alternatively, when the real exchange rate is low, net exports increase as exports rise. This relationship helps to show the effects of changes in the real exchange rate.
Compare real interest rates to nominal interest rates
The term “interest rate” is one of the most commonly used phrases in consumer finance and fixed income investments. Of course, there are several types of interest rates: real, nominal, effective, annual and so on. The differences between the various types of rates, such as nominal and real, are based on several key economic factors. But while these technical variables may seem trivial to the uneducated, lending institutions and retailers have been taking advantage of the public’s general ignorance of these distinctions to rake in hundreds of billions of dollars over the years. Those who understand the difference between nominal and real interest rates have therefore taken a major step toward becoming smarter consumers and investors.
Nominal Interest Rate
The nominal interest rate is conceptually the simplest type of interest rate. It is quite simply the stated interest rate of a given bond or loan. This type of interest rate is referred to as the coupon rate for fixed income investments, as it is the interest rate guaranteed by the issuer that was traditionally stamped on the coupons that were redeemed by the bondholders. The nominal interest rate is in essence the actual monetary price that lenders pay to borrowers to use their money. If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them.
Real Interest Rate
The real interest rate is slightly more complex than the nominal rate but still fairly simple. The nominal interest rate doesn’t tell the whole story, because inflation reduces the lender's or investor’s purchasing power so that they cannot buy the same amount of goods or services at payoff or maturity with a given amount of money as they can now. The real interest rate is so named because it states the “real” rate that the lender or investor receives after inflation is factored in; that is, the interest rate that exceeds the inflation rate. If a bond that compounds annually has a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is only 2%. The real rate of interest could be said to be the actual mathematical rate at which investors and lenders are increasing their purchasing power with their bonds and loans. It is actually possible for real interest rates to be negative if the inflation rate exceeds the nominal rate of an investment. For example, a bond with a 3% nominal rate will have a real interest rate of -1% if the inflation rate is 4%. A comparison of real and nominal interest rates can therefore be summed up in this equation:
Nominal interest rate – Inflation = Real interest rate
Several economic stipulations can be derived from this formula that lenders, borrowers and investors can use to make more informed financial decisions.
- Real interest rates can not only be positive or negative, but can also be higher or lower than nominal rates. Nominal interest rates will exceed real rates when the inflation rate is a positive number (as it usually is). But real rates can also exceed nominal rates during deflation periods.
- A hypothesis maintains that the inflation rate moves in tandem with nominal interest rates over time, which means that real interest rates become stable over longer time periods. Investors with longer time horizons may, therefore, be able to more accurately assess their investment returns on an inflation-adjusted basis.
Effective Interest Rate
One other type of interest rate that investors and borrowers should know is called the effective rate, which takes the power of compounding into account. For example, if a bond pays 6% on an annual basis and compounds semiannually, then an investor who invests $1,000 in this bond will receive $30 of interest after the first 6 months ($1,000 x .03), and $30.90 of interest after the next 6 months ($1,030 x .03). The investor received a total of $60.90 for the year, which means that while the nominal rate was 6%, the effective rate was 6.09%. Mathematically speaking, the difference between the nominal and effective rates increases with the number of compounding periods within a specific time period. Note that the rules pertaining to how the AER on a financial product is calculated and advertised are less stringent than for the annual percentage rate (APR).
Applications
The chief advantage to knowing the difference between nominal, real and effective rates is that it allows consumers to make better decisions about their loans and investments. A loan with frequent compounding periods will be more expensive than one that compounds annually. A bond that only pays a 1% real interest rate may not be worth investors' time if they seek to grow their assets over time. These rates effectively reveal the true return that will be posted by a fixed-income investment and the true cost of borrowing for an individual or business.
Investors who seek protection from inflation in the fixed-income arena can look to instruments such as Treasury Inflation Protected Securities (TIPS), which pay an interest rate that is indexed to inflation. In addition, mutual funds invest in bonds, mortgages and senior secured loans that pay floating interest rates that periodically adjust with current rates.
Conclusion
Interest rates can be broken down into several subcategories that incorporate various factors such as inflation. Smart investors know to look beyond the nominal or coupon rate of a bond or loan to see whether it really fits their investment objectives. Consult your financial advisor if you need professional advice on interest rates and investments that keep up with inflation.
Define closed economy and open economy
A closed economy is one that doesn't participate in international trade. An open economy participates in international trade. A country's best bet is to participate in international trade. A closed economy will more likely suffer economic problems.
Closed economy is an economy, which does not have any sort of economic relation with rest of the world but is confined to itself only. A closed economy does not enter into any one of the following activities.
(i) It neither exports goods and services to the foreign countries nor imports goods and services from the foreign countries.
(ii) It neither buys shares, debentures, bonds etc. from foreign countries nor sells shares, debentures, bonds etc. to foreign countries.
(iii) It neither borrows from the foreign countries nor lends to the foreign countries.
(iv) It neither receives gifts from foreigners nor sends gifts to foreigners.
(v) Normal residents of a closed economy cannot go to other countries to work in their domestic territory. No foreigner is allowed to work in the domestic territory of a closed economy.
Due to all these seasons, Gross Domestic Product and Gross National Product are the same in a closed economy.
On the other hand, an open economy is one, which is not only involved in the process of production within its domestic territory but also can participate in production anywhere in the rest of the world. An open economy involves itself in the following activities.
It buys shares, debentures, bonds etc. from foreign countries and sells shares, debentures, bonds etc. to foreign countries.
It borrows from foreign countries and lends to foreign countries.
It can send gifts and remittances to foreigners and can receive the same from them.
Normal residents of an open economy can move or be employed and are allowed to work in the domestic territory of other economies.
Due to these reasons, Gross Domestic Product and Gross National Product are not same in an open economy. It is to be noted that at present all economies of the world are open economies.
