Exchange Rate Regimes

The impact of the inherent volatility and unpredictability of exchange rates on macroeconomic conditions is central to the debate about fixed and flexible exchange rates. Real exchange rates are defined as nominal rates adjusted for price levels. Since prices for individual countries, when expressed in a common currency, are subject to the variability of exchange rates, bilateral real exchange rates based on individual-country price levels may be infected with measurement errors. The use of one reference country, such as the USA, gives rise to asymmetries.
By definition, the exchange rate is a relative price of two assets and, like other asset prices, is determined in a forward-looking manner in which expectations concerning the future course of events play a key role. Consequently, exchange rates are very sensitive to the receipt of new information.
The large and sustained changes in nominal and real exchange rates were among the most significant developments in the world economy in the 1980s. For example, in the first half of the decade, the US dollar appreciated by about 40 per cent against most other major currencies and then, in the second half of the decade, declined, reversing all the previous appreciation. These changes gave rise to international pressures associated with rapidly changing competitiveness of exports. intervention by central banks in foreign exchange markets. and intense debate regarding the extent to which these exchange rate changes interact with current account imbalances. Some economists feel that conventional measures of economic growth based on the output of goods and services (gross national product) do not satisfactorily reflect economic welfare, arguing that they ignore factors such as pollution and the negative externalities from congestion.