Chapter 11 — Trade, Capital Flows, and Exchange Rates

Core question

When a currency moves, which prices and quantities change—and why can the same depreciation help exporters, hurt importers, and raise inflation?

Learning outcomes

You will be able to:

• connect net exports to saving, investment, and capital flows;
• calculate nominal and real exchange-rate changes without reversing the quote;
• trace depreciation through contracts, import prices, inflation, and trade volumes;
• explain purchasing-power parity, exchange-rate regimes, and the policy trilemma.

1. One economy, two cross-border ledgers

Exports are domestic production sold abroad; imports are foreign production bought at home:

Imports are subtracted in Y = C + I + G + NX only because they are already counted inside consumption, investment, or government spending. The subtraction removes foreign production; it is not a claim that imports are harmful.

National accounting also gives:

in a simplified setting. If domestic investment exceeds national saving, the difference is financed from abroad and the country runs an external deficit. This may finance productive capital or fragile consumption; the sign alone cannot tell us which.

2. Fix the quote before doing arithmetic

Let

If e rises, foreign currency costs more: the domestic currency depreciates. If e falls, it appreciates.

Worked example

The pound–dollar quote moves from £0.75/$ to £0.84/$:

The pound has depreciated 12% under this quote. A $100 input rises from £75 to £84 before hedging, mark-up adjustment, or other costs.

Never write “the exchange rate increased” without defining the numerator and denominator.

3. Nominal versus real exchange rates

The nominal rate converts currencies. The real rate compares goods prices:

where P* is the foreign price level and P the domestic price level. Under our convention, a rise in q is a real depreciation: foreign goods become more expensive relative to domestic goods.

Suppose e rises 10%, foreign prices rise 2%, and domestic prices rise 6%. Approximately:

Domestic inflation therefore offsets part of the nominal depreciation's competitive effect.

4. Why currencies move

The exchange rate is an asset price shaped by expected future returns and risk, not just today's exports.

“Other things equal” matters: exchange rates combine many forward-looking forces at once.

5. Trace depreciation in stages

The timing problem

Prices can change before quantities. Existing invoices and energy contracts may be in foreign currency, while consumers and firms need time to switch suppliers. The trade balance can therefore worsen first and improve later—the J-curve possibility.

For a depreciation eventually to improve the trade balance, export and import quantities must respond sufficiently to relative prices. Supply capacity, invoicing currency, imported content of exports, and global demand all matter.

Firm-level example

A UK manufacturer sells a machine for £10,000 and imports a $4,000 component.

• At £0.75/$, the component costs £3,000.
• After depreciation to £0.84/$, it costs £3,360.
• The export price is cheaper in dollars if the pound price stays fixed, but the firm's margin is £360 lower before any quantity response.

The label “exporter” does not guarantee that a firm benefits; imported inputs can reverse the effect.

6. Exchange-rate pass-through is incomplete and uneven

Pass-through asks how much an exchange-rate change reaches import prices and then consumer prices. Firms may absorb part in margins, hedge currency risk, use existing inventories, or price in a dominant foreign currency.

An IMF study using monthly data for sub-Saharan African economies found sizable but heterogeneous inflation effects. Pass-through was larger and more persistent for large or persistent depreciations and varied with exchange-rate regime, resource structure, product-market competition, and monetary credibility (Kemoe et al., 2024).

This is regional evidence, not a coefficient to copy into every country. It teaches the right question: which imports, contracts, institutions, and expectations transmit this particular movement?

7. Two benchmarks, neither a daily forecast

Purchasing-power parity

Relative PPP predicts that a country with persistently higher inflation tends to experience currency depreciation:

Transport costs, tariffs, non-traded services, product differences, market power, and capital flows allow large and persistent deviations. PPP is more useful as a long-run benchmark than a short-run trading rule.

Interest parity

Comparable assets must offer expected returns that compensate for expected currency movement and risk. A high domestic interest rate may therefore signal an attractive return—or expected depreciation and risk. Observing the rate alone is insufficient.

8. Regimes and the policy trilemma

With sustained capital mobility, a country cannot simultaneously maintain all three:

1. a fixed exchange rate;
2. independent monetary policy;
3. free capital movement.

It can reliably choose at most two. This trilemma is a constraint, not a ranking of regimes.

9. Running case: energy shock plus depreciation

Return to the energy-importing economy from Chapter 9. World gas prices rise 40%, while its currency depreciates 10% against the invoicing currency.

If the changes compound fully, the domestic-currency price factor is:

or a 54% increase—not 50%. Actual consumer pass-through may be lower because of contracts, taxes, regulated prices, hedging, and margins.

Diagnosis:

1. the import bill and firms' marginal costs rise;
2. real household income falls;
3. SRAS shifts left and AD may weaken;
4. inflation can rise even as output falls;
5. fiscal support, rates, reserves, and the exchange regime interact.

Practice: external-sector briefing

A small economy has a 6% current-account deficit, strong equipment investment, foreign-currency corporate debt, and a 15% depreciation.

1. Explain why the deficit is not automatically bad.
2. Calculate the domestic cost change of a $2 million debt payment.
3. Separate export competitiveness from balance-sheet damage.
4. Identify two conditions that determine inflation pass-through.
5. Recommend data needed before choosing monetary, fiscal, or exchange-market action.

Quick check

• Imports are subtracted to isolate domestic production, not to label them harmful.
• Always define an exchange-rate quote before naming appreciation or depreciation.
• Nominal depreciation need not become an equal real depreciation.
• Trade volumes, prices, and balance sheets adjust at different speeds.
• Exchange-rate pass-through and regime choice depend on institutions and context.

Next: integrate the course through two evidence-based cases.