DOLLAR-YEN MARKETThe nominal exchange rate is determined by supply and demand.It is the price of a country’s money in terms of another country’s money.Money is an asset whose quantity is determined by government policy.
DOLLAR-YEN MARKETThe exchange rate determines the price of imports and of exports.This can have major effects on aggregate output and the aggregate price level.Governments can adopt a variety of exchange rate regimes.
EXCHANGE RATE REGIMES An exchange rate regime is a rule governing policy toward the exchange rate. There are two main kinds of exchange rate regimes:1. Fixed exchange rate: when the government keeps the exchange rate against some other currency at or near a particular target (Hong Kong keeps an exchange rate of HK$7.80 per US$1)
EXCHANGE RATE REGIMES2. Floating exchange rate: when the government lets the exchange rate fluctuate wherever the market takes it (this is the regime followed by the U.S., Britain, and Canada). Countries can adopt compromise policies that lie somewhere between fixed and floating exchange rates.
EXCHANGE RATE REGIMES Countries can have exchange rates that are fixed at any given time, but are adjusted frequently, exchange rates that are fixed at any given time but are adjusted frequently, exchange rates that aren’t fixed but are “managed” by the government to avoid wide swings, and exchange rates that float within a “targeted zone”.
HOW CAN AN EXCHANGE RATE BE HELD FIXED? When the exchange rate of a currency is below the target exchange rate, there are 3 ways the government can support the value of the currency to keep the rate where it wants it:1. The government can “soak up” the surplus by buying its own currency in the foreign exchange market. This is called exchange market intervention. In order to do this, the government maintains foreign exchange reserves, which are stocks or foreign currency that they can use to buy their own currency to support its price.
HOW CAN AN EXCHANGE RATE BE HELD FIXED? An important part of international trade flows is the purchases and sales of foreign assets by governments and central banks. Government sell foreign assets because they are supporting their currency through exchange market intervention.
HOW CAN AN EXCHANGE RATE BE HELD FIXED?2. Another way for a government to support its currency is to try to shift the supply and demand curves for the currency in the foreign exchange market. Governments usually do this by changing monetary policy, raising the interest rate to increase capital flows into the country, and increasing demand for its currency. This will also reduce the capital flows out of the country, reducing the supply of the currency. Therefore, other things equal, and increase in a country’s interest rate will increase the value of its currency.
HOW CAN AN EXCHANGE RATE BE HELD FIXED?3. Third, the government can support the currency by reducing its supply to the foreign exchange market. It can do this by requiring domestic residents who want to buy foreign currency to get a licence, and giving these licenses only to people with engaging in approved transactions (such as importing essential goods). Licensing systems that limit the right of individuals to buy foreign currency are called foreign exchange controls. Other things equal, foreign exchange controls increase the value of a country’s currency.
HOW CAN AN EXCHANGE RATE BE HELD FIXED? If the equilibrium value of a currency is above the target rate, and there is a shortage of the currency:To maintain the target exchange rate the government can:
HOW CAN AN EXCHANGE RATE BE HELD FIXED?1. It can intervene in the foreign exchange market, by selling its currency and buying foreign currency, which will be added to its foreign exchange reserves.2. It can reduce the interest rates to increase the supply of its currency, and reduce the demand.
HOW CAN AN EXCHANGE RATE BE HELD FIXED?3. The government can impose foreign exchange controls that limit the ability of foreigners to buy the currency.All of these actions, other things equal, will reduce the value of the currency.The choice of exchange rate regime poses a dilemma for policy makers because fixed and floating exchange rates each have advantages and disadvantages.
HOW CAN AN EXCHANGE RATE BE HELD FIXED?The choice of exchange rate regime poses a dilemma for policy makers because fixed and floating exchange rates each have advantages and disadvantages.
ADVANTAGES OF FIXED EXCHANGE RATES1. One benefit of a fixed exchange rate is the certainty about the future value of a currency.2. Adopting a fixed exchange rate also means that a country is committing itself not to engage in inflationary policies, because these policies would destabilize the exchange rate.
DISADVANTAGES OF FIXED EXCHANGE RATES1. To stabilize an exchange rate through intervention, a country must keep large quantities of foreign currency on hand, and this currency is usually a low-return investment.2. Even large reserves can be quickly exhausted when there are large capital flows out of the country.
DISADVANTAGES OF FIXED EXCHANGE RATES3. If a country chooses to stabilize an exchange rate by adjusting monetary policy, it must divert monetary policy away from other goals, such as stabilizing the economy and managing the rate of inflation.4. Foreign exchange controls, such as import quotas and tariffs, distort incentives for importing and exporting goods and services., and also may create substantial costs in terms of red tape and corruption.
DILEMMA WITH EXCHANGE RATESSo the options are:1. Let the currency float, which leaves monetary policy available for macroeconomic stabilization, but creates uncertainty for everyone affected by trade, or2. Fix the exchange rate, which eliminates trade uncertainty, but means giving up monetary policy, adopting exchange controls, or both.