Exchange Rate Systems: Fixed, Floating, and Managed
Exchange Rate Systems
Exchange Rate
The price of one currency in terms of another currency. Exchange rates can fluctuate under a floating exchange rate system (appreciation/depreciation) or be adjusted by governments under a fixed exchange rate system (revaluation/devaluation).
Floating Exchange Rate
The exchange rate is determined by the interaction of demand and supply of the currency in the foreign exchange market.
Fixed Exchange Rate System
The price of one currency in terms of another is fixed by the government at a certain rate.
Consequences of Depreciation
- Positive Effects:
- Price of exports decreases (in foreign currency), demand for exports increases, export revenue increases.
- Price of imports increases (in domestic currency), demand for imports decreases, import expenditure decreases, improving the current account balance (X-M).
- (X-M) is a component of aggregate demand (AD), so AD increases, shifting the AD curve to the right.
- Real GDP (Y) increases, boosting economic growth.
- Jobs in export sectors increase.
- Negative Effects:
- Price of imports (in domestic currency) increases, making imported raw materials more expensive and increasing the cost of production, leading to inflationary pressure.
Factors Influencing the Impact of Depreciation on Exports:
- Economic status of trading partners: If the global economy is in recession, demand for exports may not increase even if they are cheaper.
- Relative price of exports in the market: If other currencies are also depreciating, the price advantage may be lost as the relative price of exports may not drop.
- Price elasticity of demand for exports and imports: Depreciation of currency would only improve (X-M) when the Marshall-Lerner condition is satisfied: PED (X) + PED (M) > 1.
Impact on Long-Term Investment: Depreciation can attract long-term investment by multinational corporations seeking lower production costs.
Impact on SRAS and AD: Depreciation can lead to a leftward shift in the short-run aggregate supply (SRAS) curve due to higher import costs, increasing the average price level and causing inflationary pressure. However, it can also lead to a rightward shift in the AD curve due to increased net exports, further contributing to inflationary pressure.
Consequences of Appreciation
- Negative Effects:
- Price of exports increases, reducing export demand.
- Price of imports decreases, increasing import demand.
- (X-M) decreases, worsening the current account balance.
- Lower (X-M) leads to lower AD and lower economic growth.
- Jobs in export sectors decrease.
- Positive Effects:
- Reduces inflationary pressure.
Factors Influencing the Impact of Appreciation on Exports:
- Economic status of trading partners: A strong global economy can mitigate the negative impact of appreciation on export demand.
- Relative price of exports: If the appreciating currency’s exports remain relatively cheaper than those of other countries, the impact on export revenue may be limited.
- Price elasticity of demand for exports and imports: If the price elasticity of demand for exports is low (PED (X) < 1), even if exports become more expensive, the decrease in demand may be proportionally smaller, and export revenue may not decrease significantly.
Devaluation and Revaluation
- Devaluation: The deliberate downward adjustment of the exchange rate by the government to reduce the value of the currency under a fixed exchange rate system. This can be achieved by selling the domestic currency in the foreign exchange market.
- Revaluation: The deliberate upward adjustment of the exchange rate by the government to increase the value of the currency under a fixed exchange rate system. This can be achieved by buying the domestic currency in the foreign exchange market.
Reasons for Maintaining an Undervalued Currency/Devaluation
- A weaker currency makes exports cheaper (in foreign currency), increasing export competitiveness and boosting exports.
- Increased exports lead to higher aggregate demand and economic growth.
Reasons for Maintaining an Overvalued Currency/Revaluation
- A stronger currency makes imports cheaper (in domestic currency), reducing the cost of production and inflationary pressure.
Managed Exchange Rate System
The exchange rate is allowed to float within a certain range, but the government intervenes to prevent excessive fluctuations. For example, if the exchange rate appreciates beyond a certain point, the government may sell its currency and buy foreign currency to increase supply and lower the value of the domestic currency.
Advantages and Disadvantages of Floating Exchange Rates
- Advantages:
- Monetary policy autonomy: Countries can adjust interest rates to achieve domestic macroeconomic objectives without being constrained by a fixed exchange rate.
- No need to hold large reserve assets: Unlike fixed exchange rate systems, floating systems do not require governments to hold significant foreign exchange reserves to maintain a specific rate.
- Disadvantages:
- Uncertainty for trade: Fluctuating exchange rates can create uncertainty for businesses engaged in international trade, making it difficult to predict costs and revenues.
- Increased speculation: Floating exchange rates can be more susceptible to speculative activities, which can lead to excessive volatility.
Advantages and Disadvantages of Fixed Exchange Rates
- Advantages:
- Certainty for trade: Fixed exchange rates provide businesses with greater certainty about future exchange rates, reducing risks and encouraging international trade and investment.
- Reduced speculation: Fixed rates can discourage speculative activities as the exchange rate is not expected to fluctuate significantly.
- Disadvantages:
- Loss of monetary policy autonomy: Countries with fixed exchange rates lose the ability to independently adjust interest rates to address domestic economic conditions.
- Need to hold reserve assets: Governments need to maintain significant foreign exchange reserves to intervene in the market and defend the fixed exchange rate.