Overview
• Fixed exchange rates[]
A fixed exchange rate is an exchange rate that is matched to the value of another currency, a basket of other currencies, or something else to measure the value, like gold. The exchange rate is not allowed to appreciate or depreciate with the market. It is kept at the same value by government controls.
A fixed exchange rate should reduce uncertainties for all economic agents in the country. As businesses have the perfect knowledge that the price is fixed and therefore not going to change they can plan ahead in their productions. Inflation may have a harmful effect on the demand for exports and imports. To ensure that inflation is kept as low as possible the government is forced to take measurements, to keep businesses competitive in foreign markets. In theory a fixed exchange rate should also reduce speculations in foreign exchange markets. In reality this is not always the case as countries want to make speculative gains.
The government keeps the exchange rate fixed by manipulating the interest rates. If the exchange rate is in danger of falling the government needs to increase interest rates to increase demand for the currency. As this would have a deflationary effect on the economy, the demand might decrease and unemployment might increase. A government can keep a fixed exchange rate by buying and selling their currency. A government has to maintain high levels of foreign reserves to keep the exchange rate fixed as well as to instill confidence on the foreign exchange markets. This makes clear that a country is able to defend its currency by the buying and selling of foreign currencies. Fixing the exchange rate is not easy as there are many variables which change over time. If the exchange rate is set wrong it might be hard for export companies to be competitive in foreign countries. International disagreement might be created when a country sets its exchange rate on too low a level. This would make a country's export more competitive which might lead to a disagreement between countries as they might see it as an unfair trade advantage.
It is interesting to note that currently, no major economies use fixed exchange rates, other than those using the Euro.
• Floating exchange rates[]
As the exchange rate does not have to be kept at a certain level anymore interest rates are free to be employed as domestic management policies. The floating exchange rate is adjusting itself to keep the current account balanced, in theory. As the reserves are not used to control the value of the currency it is not necessary to keep high levels of reserves (like gold) of foreign countries.
Floating exchange rates tend to create uncertainty on the international markets. As businesses try to plan for the future it is not easy for the businesses to handle a floating exchange rate which might vary. Therefore investment is more difficult to assess and there is no doubt that excursive exchange rates will reduce the level of international investment as it is difficult to assess the exact level of return and risk. Floating exchange rates are affected by more factors than only demand and supply, such as government intervention. Therefore they might not necessarily adjust themselves in order to eliminate current account deficits. The floating exchange rate might worsen existing levels of inflation. If a country has higher inflation rate than others this will make the export of the country less competitive and its imports more expensive. Then the exchange rate will fall which could lead to even higher import prices of goods and because of cost-push inflation which might drive the overall inflation rate even more.
• Managed exchange rates[]
Managed exchange rate systems permit the government to place some influence on an exchange rates that would otherwise be freely floating. Managed means the exchange rate system has attributes of both systems. On one hand allowing one's currency to be dictated in its entirety by a foreign nation would be undesirable since exogenous shocks from the pegged country would affect your currency. There would be little control of the Central Bank to change expectations or impact the economy through a change in the exchange rate (thus impact interest rates through supply and demand for domestic currency) as the entire exchange system would be dependent on the foreign nation's policies. The central bank will also be in a position to utilize monetary policy to its advantage, or essentially, the changes in monetary policy will have their desired effect on a market where the exchange is not fixed. Canada uses a managed exchange rate. they do not peg to the USD, and in fact permit the exchange rate to float so long as it remains with a certain target (which varies). If the CB doesn't like how much the dollar declines they can put in place measures to slow a depreciation or appreciation. However, the central banks power to change the exchange rate trend through the markets is usually limited as their influence cannot match the overall buying power of the global market.
Different mechanisms for changing exchange rates[]
- • depreciation v. devaluation
Depreciation is a decrease in the value of assets and devaluation is the reduction in the currency of a country. When a currency is fixed or managed, countries can artificially devalue currency so that it's currency depreciates in relation to other countries. This means that the value of the currency will be lower than it would be if it were allowed to float to it's equilibrium level in the world money market. Think RMB.
- • appreciation v. revaluation
When a currency is fixed or managed, a country can revalue it's currency so that it appreciates against other currencies. The value of the currency would be higher than it would be if it were allowed to float to equilibrium levels. Think euro.
• Determinants of exchange rates[]
- • trade flow
- • capital flows/interest rate changes
- • inflation
- • speculation
- • use of foreign currency reserves
- • debt/political stability
- • Relative strength of other currencies
- • Balance of Payments
- • Change in competitiveness