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Wednesday, 04 Jul 2018

Was Free-Flooating The Pound Inevitable?

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An economy’s real exchange rate plays an important role in resource allocation as it determines the relative price of tradable and nontradable goods. It also guides the consumption and investment decisions of economic agents. Exchange rate misalignment occurs when the real exchange rate becomes disassociated from its equilibrium value and this may arise due to an economic shock with a significantly destabilizing effect, frictions in the foreign exchange market that prohibit efficient price discovery, or a policy intervention such as supporting a currency peg. Regardless of its cause, the misalignment results in the misallocation of resources between the tradable and nontradable sectors and tends to create an unsustainable balance of payments position, possibly leading to a currency crisis.

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