Exchange Rate Systems: Fixed, Floating, and Managed
Exchange Rate Systems
What is an Exchange Rate?
An exchange rate is the price of one currency in terms of another. Changes in exchange rates can lead to appreciation (increase in value) or depreciation (decrease in value) under a floating exchange rate system. Under a fixed exchange rate system, these changes are referred to as revaluation and devaluation, respectively.
Types of Exchange Rate Systems
Floating Exchange Rate System
In a floating exchange rate system, the exchange rate is determined by the forces of demand and supply in the foreign exchange market.
Fixed Exchange Rate System
In a fixed exchange rate system, the government sets the exchange rate at a specific level against another currency.
Managed Exchange Rate System
A managed exchange rate system allows the exchange rate to fluctuate within a certain range. The government intervenes when the rate moves outside of this predetermined band. For example:
- If the exchange rate is above the upper limit, the government sells its domestic currency and buys foreign currency to increase supply and bring the rate down.
- If the exchange rate is below the lower limit, the government buys its domestic currency and sells foreign currency to increase demand and push the rate up.
Consequences of Depreciation
A depreciation of a currency can have several consequences:
- Increased Exports: The price of exports decreases in foreign currency, making them more competitive and potentially leading to higher export revenue.
- Decreased Imports: The price of imports increases in domestic currency, potentially leading to lower import expenditure.
- Improved Current Account Balance: The increase in exports and decrease in imports can improve the current account balance (the difference between exports and imports).
- Boost to Economic Growth: The increase in net exports (exports minus imports) can boost aggregate demand (AD) and stimulate economic growth.
- Job Creation in Export Sectors: Increased exports can lead to job creation in export-oriented industries.
- Inflationary Pressure: The increased price of imports, especially raw materials, can lead to higher production costs and inflationary pressure.
Factors Affecting the Impact of Depreciation:
- Economic Status of Trading Partners: If trading partners are experiencing a recession, demand for exports may not increase significantly even if they become cheaper.
- Relative Price of Exports: If other countries’ currencies are also depreciating, the price advantage of exports may be reduced.
- Price Elasticity of Demand for Exports and Imports: The Marshall-Lerner condition states that depreciation will improve the current account balance only if the sum of the price elasticities of demand for exports and imports is greater than one.
Consequences of Appreciation
An appreciation of a currency can have the opposite effects of depreciation:
- Decreased Exports: The price of exports increases in foreign currency, making them less competitive.
- Increased Imports: The price of imports decreases in domestic currency.
- Worsened Current Account Balance: The decrease in exports and increase in imports can worsen the current account balance.
- Reduced Economic Growth: The decrease in net exports can reduce aggregate demand and economic growth.
- Job Losses in Export Sectors: Decreased exports can lead to job losses in export-oriented industries.
- Reduced Inflationary Pressure: The decreased price of imports can reduce inflationary pressure.
Devaluation vs. Depreciation
Both devaluation and depreciation refer to a decrease in the value of a currency. However, devaluation is a deliberate action taken by the government under a fixed exchange rate system, while depreciation occurs naturally in a floating exchange rate system due to market forces.
Reasons for Maintaining an Undervalued Currency/Devaluation
Governments may choose to maintain an undervalued currency or devalue their currency to:
- Boost Exports: A weaker currency makes exports cheaper and more competitive, potentially leading to higher export revenue and economic growth.
Reasons for Maintaining an Overvalued Currency/Revaluation
Governments may choose to maintain an overvalued currency or revalue their currency to:
- Reduce Inflationary Pressure: A stronger currency makes imports cheaper, which can help reduce inflationary pressure, especially if the country relies heavily on imported goods.
Advantages and Disadvantages of Floating Exchange Rates
Advantages:
- Monetary Policy Autonomy: Countries with floating exchange rates can independently adjust interest rates to achieve macroeconomic objectives, such as controlling inflation or stimulating economic growth.
- No Need to Hold Large Reserve Assets: Governments do not need to hold large reserves of foreign currency to maintain a fixed exchange rate.
Disadvantages:
- Uncertainty for Trade: Fluctuating exchange rates can create uncertainty for businesses involved in international trade, making it difficult to plan and price goods and services.
- Increased Speculation: Floating exchange rates can be more susceptible to speculation, which can lead to volatility and instability.
Advantages and Disadvantages of Fixed Exchange Rates
Advantages:
- Certainty for Trade: Fixed exchange rates provide certainty for businesses involved in international trade, as they know the exact price of goods and services in foreign currency.
- Reduced Speculation: Fixed exchange rates can discourage speculation, as the government is committed to maintaining the exchange rate at a specific level.
Disadvantages:
- Loss of Monetary Policy Autonomy: Countries with fixed exchange rates cannot independently adjust interest rates to achieve macroeconomic objectives, as they must maintain the exchange rate at the fixed level.
- Need to Hold Reserve Assets: Governments need to hold large reserves of foreign currency to intervene in the foreign exchange market and maintain the fixed exchange rate.