Exchange rates

Step 1. Read the rate change correctly. Each dollar now buys 5 pesos rather than 4, so the dollar has appreciated against the peso. Equivalently, the peso has depreciated: it was worth $0.25 and is now worth $0.20.

Step 2. Calculate the export price in dollars, before and after. Before: 20,000 / 4 = $5,000. After: 20,000 / 5 = $4,000. The machine is $1,000 cheaper to a dollar-paying buyer, so peso exports have become more competitive.

Step 3. Calculate the import cost in pesos, before and after. Before: $6,000 x 4 = 24,000 pesos. After: $6,000 x 5 = 30,000 pesos. The components cost 6,000 pesos more, so imports have become dearer for the peso economy.

Step 4. State who gains and who loses. From the peso economy's point of view its currency has depreciated: exporters gain because their goods are cheaper abroad, and importers lose because foreign goods cost more. From the dollar economy's point of view the reverse holds. Every exchange rate movement helps one side of each economy and harms the other.

Step 5. Remember the mnemonic and its limits. SPICED captures it: Strong Pound, Imports Cheap, Exports Dear. It works for any currency. But it describes prices only. Whether the trade balance actually improves depends on how much quantities respond, which is a separate question.

Always state which currency you are viewing the change from. The same movement is an appreciation for one country and a depreciation for the other, and answers that do not fix a viewpoint contradict themselves halfway through.

Step 1. Establish the inflation differential. Domestic inflation of 14% against partner inflation of 4% gives a differential of approximately 10 percentage points. Domestic goods have become 10% dearer relative to foreign goods before any exchange rate effect.

Step 2. Set the nominal depreciation against it. The nominal depreciation of 12% makes domestic goods cheaper to foreigners by roughly 12%. The inflation differential of 10% works the other way.

Step 3. Find the net effect on the real exchange rate. Approximately 12% gain minus 10% loss leaves a real depreciation of about 2%. Almost the entire nominal movement has been offset by relative inflation.

Step 4. Interpret for policy. The country gained only a fraction of what the headline depreciation suggests. A government relying on depreciation to restore competitiveness will find the benefit eroded unless domestic inflation is brought into line with partners', because the same depreciation that improves competitiveness raises import prices and therefore feeds domestic inflation.

Step 5. Note the self-defeating loop. Depreciation raises the cost of imported inputs and finished goods, which raises domestic inflation, which erodes the real depreciation. In an economy with a high import share and wages indexed to prices, this loop can offset a nominal depreciation almost entirely, which is why depreciation is a weak instrument for a persistent competitiveness problem.

Step 5 is the strongest evaluative point available on this topic. Depreciation addresses the symptom of uncompetitiveness while its inflationary consequence recreates the cause, so it buys time rather than solving the problem.

D, B, C, A, F, E, G

1. A government pegs its currency and commits to defending the rate.
2. The domestic economy enters recession, so the appropriate domestic policy is a cut in interest rates to stimulate demand.
3. Lower interest rates make domestic assets less attractive to foreign investors, so capital flows out.
4. Capital outflow means the currency is being sold, putting downward pressure on the pegged rate.
5. To defend the peg the central bank must buy its own currency with foreign reserves, and raise interest rates to attract capital back.
6. Raising interest rates is the opposite of what the recession requires, so output falls further and unemployment rises.
7. The government must choose between the peg and the domestic economy, and if reserves run down before confidence returns, the choice is made for it and the peg breaks.

This is the impossible trinity in narrative form: a country cannot simultaneously have a fixed exchange rate, free capital movement and an independent monetary policy. It can have any two. Naming that trade-off explicitly is a reliable way into the higher bands.

Define and frame: Define both systems and note that most real regimes are intermediate. State that 'developing economy' changes the answer, because such economies typically have thinner reserves, higher inflation, foreign currency debt and less institutional credibility, and say you will test the systems against those specific features rather than in the abstract.

Analysis: the case for floating: Automatic adjustment towards external balance without reserves being spent. Monetary policy freed for domestic objectives, which matters where unemployment and growth are pressing. No vulnerability to speculative attack on a defended level, since there is no level to defend. Support with a forex diagram showing the rate adjusting to eliminate an excess supply of the currency.

Analysis: the case for fixing: Certainty encourages trade and inward investment, which matters most where foreign capital is scarce. A peg imports monetary discipline and can anchor inflation expectations where a central bank lacks credibility of its own, which is a strong argument in high-inflation economies. It also protects borrowers with foreign currency debt, since depreciation raises the domestic cost of servicing it, a danger largely absent in advanced economies.

Evaluation: Weigh the conditions. The impossible trinity means the real choice is which two of fixed rate, capital mobility and monetary independence to keep, and a developing economy may reasonably choose capital controls to keep the other two. Reserves determine whether a peg is defensible at all. The composition of debt matters: heavy foreign currency borrowing makes floating dangerous. And volatility under floating is worse for economies dependent on a few primary commodity exports, whose prices are themselves volatile.

Judgement: Conclude conditionally. A peg is preferable where inflation credibility is the binding problem, where reserves are adequate and where foreign currency debt is large. Floating is preferable where shocks are frequent and asymmetric, where reserves are thin, and where monetary independence is needed for domestic objectives. Note that many developing economies sensibly adopt a managed float as a compromise, and say what determines where on that spectrum a given country should sit.