Exchange rate systems
Exchange rate is the value of a currency measured in terms of another currency. These days, different countries use different currencies to pay for international trade. Therefore, exchange rates and a foreign exchange market exist and countries operate different types of exchange rate systems. According to Powell (2005), there are three different types of exchange rate systems: freely floating exchange rates, fixed exchange rates and managed exchange rates.
Freely floating (or cleanly floating) exchange rates are an exchange rate which is set by the market without any intervention by central banks or governments. In other words, there is no government or central bank action to keep it stable in a regime of freely floating exchange system. Therefore, the price of a currency in terms of another currency or currencies is determined by the forces of demand and supply alone and foreign exchange markets are places where the external value of a country's currency is determined. Consequently, both trade flows and capital flows affect the exchange rate under a floating exchange rate system.
These days, there are many countries that adopt floating exchange rates as their exchange rate system. Mankiw and Taylor (2006) say that the UK (UK pound), USA (US dollar) and Japan (Japanese Yen) are good examples among them. Especially, according to Powell (2005), the UK government changed its exchange rate system from an adjustable peg system to freely floating exchange rates after 1992.
In the foreign exchange market, UK residents will be supplying pounds and demanding foreign currencies if they want to purchase foreign goods and services while foreign customers wishing to buy UK products and services will be demanding pounds and supplying their currencies. Therefore, there will be the equilibrium price. The graph below shows the equilibrium exchange rate, expressed against the US dollar.
(adopted from Grant: p.488)
However, according to Powell (2005), there are two assumptions on freely floating exchange rates. First of all, there are no capital flows. Moreover, he states that the other assumption is that any holdings of foreign currencies surplus to the immediate requirement of paying for trade are immediately sold on the foreign exchange market.
According to the figure above, the equilibrium exchange rate of pounds in terms of the US dollar is $1.5 when demand for pounds is D and supply is S1. However, this equilibrium price can be changed as the demand and supply are altered. The graph below shows how a new equilibrium exchange rate is determined in a freely floating exchange rate system.
(adopted from Powell: p.425)
If there is an improvement in the quality of foreign goods and services, the demand for foreign currencies will increase because UK residents will raise their demand for imports. Therefore, the supply curve of sterling shifts rightward from S1 to S2. The rationale behind this is that the demand for foreign exchange to pay for imports rises. As long as the exchange rate stays at $1.50, the current account is in deficit by £8 billion and there is the excess supply of pounds on the foreign exchange market. This in turn will cause depreciation in sterling because selling of pounds to get rid of excess supply causes the exchange rate to fall. Consequently, the new equilibrium exchange rate of pounds will be reached at $1.25 to the pound after the adjustment process. At this point, exports and imports are both equalling £15 billion.
Conversely, if the demand for pounds increases as a result of an improvement in the quality of UK goods and services, the exchange rate would increase to relieve the excess demand for pounds. Consequently, the demand curve for sterling shifts rightward, then create a new equilibrium at a higher exchange rate. The graph below illustrates this process.
(adopted from Grant: p.489)
In conclusion, in a regime of a floating exchange rate system, the exchange rate will be changed by the forces of demand and supply without any intervention by governments and central banks. If the demand for a currency is increased, the new equilibrium exchange rate of the currency will be raised. In contrast, if the demand for foreign currencies is increased, the new equilibrium exchange rate of a domestic currency will be depreciated to get rid of excess supply.
Unlike a floating exchange rate system, a fixed exchange rate system is one where a country's currency is fixed against other currencies by the central banks and the governments. In other words, in a regime of fixed exchange rates, a country's exchange rate remains constant.
These days, there are some countries adopting a fixed exchange rate system as their exchange rate system, e.g. Argentina (Argentine peso). Argentine peso was fixed by the central bank at 1 peso = 1 U.S dollar. Furthermore, China (Chinese renminbi) was also a nation adopting a fixed exchange rate before. Until 2005, China's currency had been tightly pegged at 8.2765 yuan to the U.S dollar.
According to Grant (2000), the central bank undertakes to maintain the exchange rate at an agreed level by means of trading the currency at the fixed price. The central banks are therefore forced to enter the foreign exchange market in order to adjust supply and demand. It means that they should have enough reserves of foreign currencies in order to purchase its domestic currency on the foreign exchange market.
The graph below illustrates how the central bank maintains a currency at a fixed value. According to the graph below, a fixed exchange rate of £1 is $2 and UK authorities have agreed this exchange rate as their equilibrium exchange rate of sterling in terms of the US dollar. Therefore, the market is in equilibrium at this price if there are no changes in supply and demand curves. However, the supply curve can shift rightward from SS to S1S1 as a result of increased imports. If there is no intervention by the central bank, the price of pounds will be reduced from £1=$2 to £1=$1.50. However, under a fixed exchange rate system, the central bank will be forced to purchase its domestic currency (in this case, the UK central bank will buy pounds). The reason is that raising demand from DD to D1D1 is necessary to maintain the fixed exchange rate (£1=$2).
(adopted from Grant: p.492)
Conversely, if the demand for the currency is higher than its supply because of increased exports, the central bank will sell its own currency and buy foreign currencies to maintain a currency at a fixed value.
In conclusion, the central bank uses its reserves of foreign currencies to adjust supply and demand and to maintain a currency at a fixed value. If the supply of the currency exceeds its demand at the fixed price, the central bank will buy its own currency by selling its reserves of foreign currencies. However, contrary to this, the central bank will sell its own currency and purchase foreign currencies if the demand for the currency exceeds its supply at the fixed price.
The managed exchange rate system is one of different types of exchange rate systems. Under a managed exchange rate, the central bank tries to achieve advantages of floating exchange rates and fixed exchange rates together. For example, stability and certainty from the fixed exchange rate system and avoiding overvaluation and undervaluation by responding to market forces.
According to Powell (2005), exchange rates are managed in two main ways. These are an adjustable peg exchange system and a managed (or dirty) floating.
The method used under an adjustable peg exchange rate system is similar to a rigid fixed system's method, but an adjustable peg system is more flexible than a rigid fixed system. The reason is that there are permitted periodic revaluations or devaluations in order to correct undervaluation or overvaluation. The graph below shows devaluation of an adjustable peg exchange rate.
(adopted from Powell: p.432)
The exchange rate is initially fixed and there is no intervention if the exchange rate stays between a ceiling and a floor. However, if the exchange rate is higher than a ceiling or is lower than a floor, the central bank intervenes in the market to maintain its exchange rate. It is same as the method used under a fixed exchange rate system. However, devaluation of the exchange rate shows the difference between an adjustable peg system and a rigid fixed system. According to Powell (2005), there are some disadvantages when the exchange rate is overvalued, e.g. condemning the country to over-priced exports, under-priced imports and a current account deficit. Devaluation is a policy to avoid overvalued exchange rate and these disadvantages.
Unlike an adjustable peg system, the exchange rate is officially floating in a regime of a managed (or dirty) floating. However, Grant (2000) states that the central bank intervenes unofficially behind the scenes. In other words, it purchase or sell their reserves to influence the exchange rate and keep a currency at a targeted value.
According to Riley (2006), there were many countries adopting a managed exchange rate system (especially a managed floating) as a policy between 1973 and 1990. The UK also operated a managed exchange rate system during that period. In the case of the UK, it set an unofficial target for sterling against the Deutschmark. The other example is China. Roger (2008) says that China reformed its exchange rate system as a managed floating. The figure below shows how the country managed and when its exchange rate system reformed.
(adopted from Roger's lecture)
The fixed exchange system has its own advantages and disadvantages. According to Powell (2005), the advantages and disadvantages of the fixed exchange rate system are closely, but oppositely related to those of the floating exchange rate system.
There are two main advantages associated with fixed exchange rates. First of all, Powell (2005) states that the fixed exchange rate system offers certainty and stability as the principal benefits. In a regime of the floating exchange rate system, the volatility and instability are created and they might slow or even destroy the growth of international trade. However, contrary to this, fixed interest rates offer certainty and stability because there are no fluctuations from the central rate. Therefore, international trade can grow on a basis of certainty and stability created by the fixed exchange rate system. Furthermore, according to Grant (2000), the negotiation of long-term contracts, the granting of long-term credits and the understaking of long-term investment overseas are less risky. The reason is that the central bank secures the exchange rate and it gives firms and investors confidence.
Powell (2005) tells us that the anti-inflationary 'discipline' imposed on a country's domestic economic management and upon the behaviour of its workers and firms is the other advantage of the fixed exchange rate system. To control inflation, the governments can use an exchange rate as its policy instrument. Especially, a high exchange rate will be useful to reduce inflation because costs of production can be decreased as a result of a high exchange rate. For example, the price of imported goods, raw materials and energy will be reduced if the exchange rate remains high. Therefore, costs of production will be decreased and, consequently, it will reduce cost-push inflationary pressure. Moreover, a high exchange rate can influence changes in human behaviour. If the exchange rate remains high, domestic businesses might lose their competitiveness because the price of their goods and services are higher than their international competitors. It means that employees are able to face the risk of unemployment if the situation will continue. Therefore, workers might ask moderate price rises and wage claims rather than pushing for higher wage increases. Consequently, a fixed exchange rate can discipline domestic inflationary pressures even though it is not available to stimulate the aggregate demand within the economy.
However, there are some disadvantages of the fixed exchange rate system. According to Grant (2000), the main disadvantage of fixed exchange rates is that the burden of adjusting the balance of payments disequilibrium tends to fall on the domestic economy. Unlike floating exchange rates, the central bank uses its reserves of foreign currencies to adjust supply and demand and to maintain a currency at a fixed value. Therefore, it will be expected that there are severe deflationary costs of lost output and unemployment if a country is in a persistent deficit. The reason is that a country may use its reserves of foreign currencies to hold up the exchange value of its currency. In addition, there will be importation of inflation by a surplus country.
Another disadvantage of the fixed exchange rate system is that there is continued overvaluation or undervaluation of the currency. The fixed exchange rate might be incorrect because there is no change in the value of a currency and it will lead to currency being undervalued or overvalued. Consequently, incorrectly valued currency could result in a trade imbalance. For instance, according to Powell (2005), there will be a possible balance of payments or currency crisis in a country whose currency is overvalued. This is because an overvalued currency can cause a trade deficit and it can also cause speculative capital movements into or out of currencies.
Unsuitable resource allocation can be a problem under a fixed exchange rate system. To maintain a currency at a fixed value, the central bank uses its reserves. Therefore, resources in official reserves will be limited or tied up. It means that official reserves will be misallocated because those resources cannot be used more productively elsewhere.
Finally, Powell (2005) tells us that there is a possible increase in uncertainty. Even though stability and certainty are advantages of the fixed exchange rates, it might also be able to cause uncertainty. For example, when overvaluation or undervaluation of a currency is expected, it will lead to uncertainty.
Under the floating exchange rate system, an exchange rate is set by the market without any intervention by central banks or governments. Therefore, exchange rates will be high or low by the forces of demand and supply. Consequently, there will be different effects as the value of the exchange rate has changed.
According to Grant (2000), there are advantages of a high exchange rate under the floating exchange rate system. First of all, she states that downward pressure on inflation is one of the advantages. If the value of a currency is stronger than other currencies, the price of imported goods and services will be relatively low and, consequently, there will be lower inflation. The reason is that domestic producers and suppliers might force stiffer international competition from the lower price of imports and it will put pressure on them to cut their prices in order not to suffer from a loss of international competitiveness. Moreover, the lower price of imported raw materials will also be helpful to remain the prices of finished domestic products low because the companies can reduce their costs of production. It means that the cheaper price of raw materials from overseas will have a negative effect on the rate of inflation.
Apart from reduced prices of domestic goods, a high exchange can also influence on wage claims. If the exchange rate remains high, the workers will face the risk of unemployment. The reason is that the domestic suppliers face stiffer international competition and they can also suffer from a loss of international competitiveness in the foreign markets as a result of a relatively high price. Therefore, it might lead workers to ask moderate wage claims and, consequently, it also help to control the rate of inflation.
As another advantage, Grant (2000) says that trade and living standards will be improved as a result of a high exchange rate. If an exchange rate is high, the price of imported goods and services will be relatively cheap. It means that more imports can be bought by the same volumes of exports. Suppose that the sterling exchange rate in terms of the US dollar is £1=$1.50. If one UK producer sell two £10 products and receive $30, the exporter can purchase six $5 goods from another country. However, if the exchange rate rises from £1=$1.50 to £1=$2, the UK supplier is able to receive $40 and buy eight $5 goods even though the producer exports the same volumes of products (in this case, two £10 products). Consequently, a high exchange rate leads to a lower price of imports and it will increase the real living standards of domestic customers because they can spend less money to purchase imports.
(source from BBC NEWS)
The graph above shows the exchange rate of pounds in terms of the US dollar during a year. The value of sterling was the highest between October to December in 2007. Therefore, UK importers could get the chance to purchase, for example, cheaper computers or motor vehicles from the United States. Furthermore, UK travellers might reduce their costs if they visit the United States during that period.
Further, she says that a high exchange rate may encourage foreign direct investment. The rationale behind this is that foreign investors can receive high profits when they send revenues to their countries and then those revenues convert into their domestic currency. For example, if one US company receive £10,000 in the UK as a result of its investment when the value of sterling in terms of the US dollar is £1=$1.50, the revenue can convert into $15,000. However, if there is appreciation in the value of pounds so it is now £1=$2, the revenue will be changed from $15,000 to $20,000 even though there is no change in the revenue by sterling. It means that successful currency speculation can lead to significant captital gains. Therefore, a high exchange rate can attract direct investments from foreign investors and it will be helpful to domestic companies who are wishing to increase their investment from overseas countries.
Finally, according to Riley (2006), if inflation is lower, then interest rates will be lower than if the exchange rate was weaker. Cheaper money will stimulate customer spending and capital spending and those activities will increase the demand for goods and services. Therefore, low interest rates can be an advantage of a high exchange rate.
Even though there are some advantages of a high exchange rate, there are also some disadvantages. First of all, a high exchange rate causes a trade deficit. This is because the lower price of imported goods and services leads domestic consumers to increase their demand for imports. Furthermore, the exports will be decreased and the sales in the domestic market will be also reduced. The reason is that the prices of their products will be more expensive to sell in the domestic market and/or foreign markets. Consequently, the exports might be reduced while the imports will be increased and then the trade will be in deficit. In addition, this can also damage profits and employment in some industries.
Moreover, a high exchange rate can slow economic growth. Riley (2006) states that if exports fall, this causes a reduction in aggregate demand and reduces the short-term rate economic growth as measured by the % change in real GDP. The graph below illustrates a fall in export demand lower GDP level.
(adopted from tutor2u.net)
Because of a high exchange rate, an aggregate demand curve shifts leftward from AD1 to AD2. Consequently, real national output will be decreased and it causes low economic growth.
Finally, according to Riley (2006), the other disadvantage of a high exchange rate is that if exports fall, then so will business confidence and capital investment. Uncertainty and instability can be expected under a floating exchange rate and it can reduce business confidence because it decreases the demand for exports. Investment is partly dependent on the strength of demand. Therefore, business confidence and investment might be reduced as a result of decreased exports and it will influence some industries and the economy.
Like the case of a high exchange rate, there are also advantages and disadvantages to a nation in having low exchange rates. Grant (2000) says that there are three advantages of a low exchange rate.
First of all, she states that domestic products and services will be price competitive in the domestic market and foreign markets. As the value of a currency in terms of other currencies is depreciated in consequence of a low exchange rate, the price of imported goods and services will be relatively high in the domestic market while the price of exported goods and services will be low in foreign markets. Therefore, domestic suppliers will have price competitiveness in both the domestic market and foreign markets.
As another advantage of a low exchange rate, Grant (2000) tells us that the balance of trade in goods and services should be in equilibrium or in surplus. This is because domestic producers have price competitiveness under a low exchange rate. The relatively cheaper price of exports in terms of other currencies will raise the exports while the relatively higher price of imports will reduce the demand for imports. Therefore, the balance of trade in goods and services will be changed and, in the end, it will be in equilibrium or in surplus.
Finally, she says that demand for domestic goods and services are likely to be high and so employment and growth are also likely to be high. The domestic consumers will choose products and services supplied by domestic suppliers as an alternative choice because the prices of imports are relatively high in the market. In addition, the relatively lower prices of exported goods and services in terms of other currencies will be more popular in foreign markets. Therefore, those cause increased demand for domestic goods and services. The increased demand, in turn, raises employment and growth because the firms will employ more workers and produce more goods to meet increased demand. Consequently, the economy can be grown as a result of a low exchange rate.
Although a low exchange rate has its own advantages, there are also some disadvantages to a nation in having a low exchange rate.
First of all, a low exchange rate can accelerate the rate of inflation because stronger demand can increase inflationary pressure. As the demand has increased, the demand for labour has also risen. Furthermore, sales of products and revenues in the domestic market and foreign markets might be increased. Those factors lead workers to ask wage claims. Apart from those reasons, high import costs might also cause an increase in wage claims because people attend to protect their real incomes. Moreover, increased prices of raw materials from overseas will increase the prices of some products. Consequently, inflation might be accelerated as a result of a low exchange rate.
The high prices of imported goods and services might be another disadvantage. The reason is that imported products can be connected with living standards. If the value of a currency in terms of other currencies is low, the price of imports is relatively expensive. It means that the country should spend more money to purchase goods and services from overseas countries. Therefore, the prices of imports will be increased and, consequently, it will influence living standards because domestic customers should pay more money when they buy imports. Moreover, if a country purchases most (or all) of its energy resources such as oil, coal etc, the problem might be more serious. This is because the prices of energy might depend on the exchange rate and the price might be high if an exchange rate is low.
The other disadvantage of a low exchange rate is that foreign direct investment can be reduced. If an exchange rate is low, the investors' profits will be decreased when their revenues convert into their own currency. Therefore, foreign investors cannot receive any incentive from a nation where an exchange rate is low. Consequently, the investment from overseas countries might be reduced if a low exchange rate continues.
In conclusion, there are different advantages and disadvantages to a nation in having low or high exchange rates. Therefore, governments and central banks should check their exchange rates regularly to reduce damages and increase benefits even though there is no intervention by them. Furthermore, they should also consider exchange rates when they develop new government polices.
DTI, 2008, BBC NEWS Market data, Available from:
http://newsvote.bbc.co.uk/1/shared/fds/hi/business/market_data/currency/11/12/twelve_month.stm, Accessed at 01/05/2008
Fletcher, R., 2008, Lecture Notes: chapter 22. Exchange Rates
Grant, S.J., 2000, STANLAKE'S INTRODUCTORY ECONOMICS, Essex, Longman
Mankiw, N.G. and Taylor, M.P., 2006, Economics, London, Thomson Learning
Powell, R., 2005, AQA advanced Economics, Oxfordshire, Philip Allan Updates
Riley, G., 2006, AS Macroeconomics / International Economy, Available from:
Accessed at 28/04/2008
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Accessed at 28/04/2008