Imagine there are two currencies, A and B. The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries.
A government should consider its economic standing, trade balance, and how it wants to use its policy tools when choosing an exchange rate regime.
When a country decides on an exchange rate regime, it needs to take several important things in account. Unfortunately, there is no system that can achieve every possible beneficial outcome; there is a trade-off no matter what regime a nation picks. Below are a few considerations a country needs to make when choosing a regime.
A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies. Developing economies often have the majority of their liabilities denominated in other currencies instead of the local currency. Businesses and banks in these types of economies earn their revenue in the local currency but have to convert it to another currency to pay their debts. Developing Countries : The developing countries, marked in light blue, may prefer a fixed or managed exchange rate to a floating exchange rate.
This is because sudden depreciation in their currency value poses a significant threat to the stability of their economies. Flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs in an economy with a floating exchange rate, there will be increased demand for the foreign rather than domestic currency which will increase the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and decreases the trade deficit.
Under fixed exchange rates, this automatic re-balancing does not occur. A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand.
In general, fixed-rates are not established by law, but are instead maintained through government intervention in the market. The government does this through the buying and selling of its reserves, adjusting its interest rates, and altering its fiscal policies. Because the government must commit its monetary and fiscal tools to maintaining the fixed rate of exchange, it cannot use these tools to address other macroeconomics conditions such as price level, employment, and recessions resulting from the business cycle.
The three major types of exchange rate systems are the float, the fixed rate, and the pegged float. One of the key economic decisions a nation must make is how it will value its currency in comparison to other currencies. An exchange rate regime is how a nation manages its currency in the foreign exchange market.
There are three basic types of exchange regimes: floating exchange, fixed exchange, and pegged float exchange. Foreign Exchange Regimes : The above map shows which countries have adopted which exchange rate regime. A currency that uses a floating exchange rate is known as a floating currency. The dollar is an example of a floating currency. Many economists believe floating exchange rates are the best possible exchange rate regime because these regimes automatically adjust to economic circumstances.
These regimes enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, they also engender unpredictability as the result of their dynamism. A fixed exchange rate system, or pegged exchange rate system, is a currency system in which governments try to maintain a currency value that is constant against a specific currency or good.
The central bank of a country remains committed at all times to buy and sell its currency at a fixed price. The most famous fixed rate system is the gold standard, where a unit of currency is pegged to a specific measure of gold. Regimes also peg to other currencies. Pegged floating currencies are pegged to some band or value, which is either fixed or periodically adjusted. These are a hybrid of fixed and floating regimes. There are three types of pegged float regimes:.
A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable and is especially useful for small economies in which external trade forms a large part of their GDP.
This belief that fixed rates lead to stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. A fixed exchange rate regime should be viewed as a tool in capital control. Typically a government maintains a fixed exchange rate by either buying or selling its own currency on the open market.
This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves.
Another, method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This method is rarely used because it is difficult to enforce and often leads to a black market in foreign currency. Some countries, such as China in the s, are highly successful at using this method due to government monopolies over all money conversion. China used this method against the U. PRC Flag : China is well-known for its fixed exchange rate. As the war was coming to an end, representatives of the United States and its allies met in at Bretton Woods, New Hampshire, to fashion a new mechanism through which international trade could be financed after the war.
The system was to be one of fixed exchange rates, but with much less emphasis on gold as a backing for the system. In recent years, a number of countries have set up currency board arrangements Fixed exchange rate systems in which there is explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed rate. In its simplest form, this type of arrangement implies that domestic currency can be issued only when the currency board has an equivalent amount of the foreign currency to which the domestic currency is pegged.
It can create reserves only when the currency board has an excess of foreign currency. If the currency board is short of foreign currency, it must cut back on reserves. Argentina established a currency board in and fixed its currency to the U. The currency board seemed to work well for Argentina for most of the s, as inflation subsided and growth of real GDP picked up. The drawbacks of a currency board are essentially the same as those associated with the gold standard.
Faced with a decrease in consumption, investment, and net exports in , Argentina could not use monetary and fiscal policies to try to shift its aggregate demand curve to the right. It abandoned the system in The mechanism for maintaining these rates, however, was to be intervention by governments and central banks in the currency market. Suppose further that this rate is an equilibrium rate, as illustrated in Figure As long as the fixed rate coincides with the equilibrium rate, the fixed exchange rate operates in the same fashion as a free-floating rate.
Figure The Bank of England could purchase pounds by selling dollars in order to shift the demand curve for pounds to D 2. Alternatively, the Fed could shift the demand curve to D 2 by buying pounds. Now suppose that the British choose to purchase more U. If the adjustment were to be made by the British central bank, the Bank of England, it would have to purchase pounds. It would do so by exchanging dollars it had previously acquired in other transactions for pounds. As it sold dollars, it would take in checks written in pounds.
When a central bank sells an asset, the checks that come into the central bank reduce the money supply and bank reserves in that country.
We saw in the chapter explaining the money supply, for example, that the sale of bonds by the Fed reduces the U. Similarly, the sale of dollars by the Bank of England would reduce the British money supply. In order to bring its exchange rate back to the agreed-to level, Britain would have to carry out a contractionary monetary policy.
Alternatively, the Fed could intervene. It could purchase pounds, writing checks in dollars. But when a central bank purchases assets, it adds reserves to the system and increases the money supply. The United States would thus be forced to carry out an expansionary monetary policy. Domestic disturbances created by efforts to maintain fixed exchange rates brought about the demise of the Bretton Woods system. Japan and West Germany gave up the effort to maintain the fixed values of their currencies in the spring of and announced they were withdrawing from the Bretton Woods system.
President Richard Nixon pulled the United States out of the system in August of that year, and the system collapsed.
An attempt to revive fixed exchange rates in collapsed almost immediately, and the world has operated largely on a managed float ever since. Under the Bretton Woods system, the United States had redeemed dollars held by other governments for gold; President Nixon terminated that policy as he withdrew the United States from the Bretton Woods system.
The dollar is no longer backed by gold. Fixed exchange rate systems offer the advantage of predictable currency values—when they are working.
But for fixed exchange rates to work, the countries participating in them must maintain domestic economic conditions that will keep equilibrium currency values close to the fixed rates. Sovereign nations must be willing to coordinate their monetary and fiscal policies. Achieving that kind of coordination among independent countries can be a difficult task. The fact that coordination of monetary and fiscal policies is difficult does not mean it is impossible. Eleven members of the European Union not only agreed to fix their exchange rates to one another, they agreed to adopt a common currency, the euro.
The new currency was introduced in and became fully adopted in Since then, six other nations have joined. The nations that adopted it agreed to strict limits on their fiscal policies. Each continues to have its own central bank, but these national central banks operate similarly to the regional banks of the Federal Reserve System in the United States. The new European Central Bank conducts monetary policy throughout the area. Details of this revolutionary venture and the extraordinary problems it has encountered in recent years are provided in the accompanying Case in Point.
When exchange rates are fixed but fiscal and monetary policies are not coordinated, equilibrium exchange rates can move away from their fixed levels. Once exchange rates start to diverge, the effort to force currencies up or down through market intervention can be extremely disruptive. And when countries suddenly decide to give that effort up, exchange rates can swing sharply in one direction or another. When that happens, the main virtue of fixed exchange rates, their predictability, is lost.
Several factors, including weakness in the Japanese economy, reduced the demand for Thai exports and thus reduced the demand for the baht, as shown in Panel a of Figure Central banks buy their own currency using their reserves of foreign currencies. We have seen that when a central bank sells bonds, the money supply falls.
When it sells foreign currency, the result is no different. That forced the central bank to buy even more baht—selling even more foreign currency—until it finally gave up the effort and allowed the baht to become a free-floating currency. By the end of , the baht had lost nearly half its value relative to the dollar. This can be aimed at stabilizing a volatile market or achieving a major change in the rate. Groups of central banks, such as those of the G-7 nations Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States , often work together in coordinated interventions to increase the impact.
An intervention is often short-term and does not always succeed. A prominent example of a failed intervention took place in when financier George Soros spearheaded an attack on the British pound. Soros believed that the pound had entered at an excessively high rate, and he mounted a concerted attack on the currency.
The failed intervention cost the U. Central banks can also intervene indirectly in the currency markets by raising or lowering interest rates to impact the flow of investors' funds into the country.
Since attempts to control prices within tight bands have historically failed, many nations opt to free float their currency and then use economic tools to help nudge it one direction or the other if it moves too far for their comfort. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content.
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