Exchange Rates: Changes Under Different Exchange Rate Systems

This section explores how exchange rates change under various exchange rate systems, including fixed, floating, and managed float regimes. We will examine the mechanisms driving these changes and the implications for international trade and investment.

1. Fixed Exchange Rate Systems

In a fixed exchange rate system, the value of a currency is pegged to another currency or a basket of currencies. The central bank actively intervenes in the foreign exchange market to maintain this fixed rate.

• Mechanism: The central bank buys or sells its own currency to offset market pressures that would otherwise cause the exchange rate to deviate from the target.
• Example: The European Exchange Rate Mechanism (ERM) – although largely dismantled – aimed to fix exchange rates between participating currencies.
• Advantages: Provides exchange rate stability, which can reduce uncertainty for businesses involved in international trade.
• Disadvantages: Requires significant foreign exchange reserves to maintain the peg. Can lead to speculative attacks if the market believes the peg is unsustainable. Limits the central bank's ability to use monetary policy to address domestic economic issues.

2. Floating Exchange Rate Systems

In a floating exchange rate system, the value of a currency is determined by the forces of supply and demand in the foreign exchange market. There is no official target rate, and the exchange rate fluctuates freely.

• Mechanism: Exchange rates adjust based on the relative supply and demand for currencies. Factors influencing demand and supply include interest rates, economic growth, inflation, and political stability.
• Example: The US dollar, Euro, and Japanese Yen are major currencies with floating exchange rates.
• Advantages: Allows monetary policy to be used to address domestic economic issues without the constraint of maintaining a fixed exchange rate. Provides a buffer against speculative attacks.
• Disadvantages: Can lead to exchange rate volatility, which can increase uncertainty for businesses involved in international trade.

3. Managed Float Systems

A managed float is a hybrid system where the exchange rate is primarily determined by market forces, but the central bank intervenes occasionally to smooth out excessive volatility or to achieve specific policy objectives.

• Mechanism: The central bank intervenes by buying or selling its own currency to influence the exchange rate. The level of intervention can vary depending on the circumstances.
• Example: Many emerging market economies operate under managed float regimes.
• Advantages: Offers a degree of exchange rate stability while still allowing for some flexibility. Can help to mitigate the risks of excessive volatility.
• Disadvantages: Requires the central bank to have sufficient foreign exchange reserves and expertise to manage the exchange rate effectively. Can be difficult to determine the appropriate level of intervention.

4. Factors Influencing Exchange Rate Changes

Several factors can cause changes in exchange rates under different exchange rate systems.

Factor	Effect on Exchange Rate
Interest Rate Differentials	Higher interest rates tend to attract foreign capital, increasing demand for the currency and causing it to appreciate. Lower interest rates tend to reduce demand for the currency and cause it to depreciate.
Economic Growth	Strong economic growth can increase demand for a country's currency, leading to appreciation.
Inflation Rates	Higher inflation rates tend to reduce the purchasing power of a currency, leading to depreciation.
Current Account Balance	A current account surplus (exports > imports) tends to increase demand for a country's currency, leading to appreciation. A current account deficit (imports > exports) tends to decrease demand for a country's currency, leading to depreciation.
Political Stability	Political stability generally increases investor confidence and can lead to appreciation of a currency. Political instability can have the opposite effect.

5. Implications of Exchange Rate Changes

Changes in exchange rates have significant implications for international trade and investment.

• Exports: A depreciation of a country's currency makes its exports cheaper for foreign buyers, potentially increasing export demand.
• Imports: A depreciation of a country's currency makes imports more expensive, potentially reducing import demand.
• Foreign Investment: Exchange rate changes can affect the profitability of foreign investments. A depreciation of a country's currency can make investments in that country more attractive to foreign investors.
• International Competitiveness: Exchange rate changes can affect the international competitiveness of domestic firms.