Exchange Rates: Changes Under Different Exchange Rate Systems

This section explores how exchange rates change under various exchange rate regimes. Understanding these systems is crucial for analyzing 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 value.

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. For example, if demand for the domestic currency increases, pushing the value up, the central bank will sell its currency and buy foreign currency. Conversely, if demand falls, the central bank will buy its own currency.

Advantages:

• Provides exchange rate stability, reducing uncertainty for businesses involved in international trade.
• Can help control inflation by imposing discipline on monetary policy.

Disadvantages:

• Requires significant foreign exchange reserves to defend the peg.
• Limits the central bank's ability to use monetary policy to address domestic economic problems.
• Can lead to speculative attacks if markets believe the peg is unsustainable.

Example: The European Exchange Rate Mechanism (ERM) – though largely dismantled – was an example of a fixed exchange rate system.

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. The central bank does not actively intervene to maintain a specific exchange rate.

Mechanism: Exchange rates fluctuate based on the relative supply and demand for currencies. Factors influencing demand and supply include interest rates, economic growth, inflation, and political stability.

Advantages:

• Allows monetary policy to be used to address domestic economic problems.
• Provides a natural buffer against external shocks.
• Reduces the need for large foreign exchange reserves.

Disadvantages:

• Creates exchange rate volatility, which can increase uncertainty for businesses.
• Can lead to currency overvaluation or undervaluation, which can distort trade patterns.

Example: The United States, the United Kingdom, and Japan have floating exchange rate systems.

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 in the foreign exchange market to influence the exchange rate, but does not commit to maintaining a specific target level. Interventions can be discretionary or based on pre-announced rules.

Advantages:

• Offers a degree of exchange rate stability while still allowing for some flexibility.
• Provides a buffer against excessive volatility.

Disadvantages:

• Can be difficult to manage effectively.
• May require the central bank to intervene frequently, which can be costly.

Example: Many emerging market economies operate under managed float systems.

4. Exchange Rate Changes and Economic Indicators

Changes in exchange rates are often linked to underlying economic indicators. Here's a table summarizing some key relationships:

Exchange Rate Change	Potential Causes	Economic Indicator Impact
Appreciation (Currency Value Increases)	Increased demand for the currency; decreased supply	Exports become more expensive Imports become cheaper Trade balance may worsen Can lead to lower inflation
Depreciation (Currency Value Decreases)	Decreased demand for the currency; increased supply	Exports become cheaper Imports become more expensive Trade balance may improve Can lead to higher inflation

5. Impact of Exchange Rate Changes

Changes in exchange rates can have significant impacts on:

• International Trade: Affects the price competitiveness of exports and the cost of imports.
• Investment: Influences the returns on foreign investments.
• Inflation: A depreciation can lead to imported inflation.
• Economic Growth: Can impact a country's overall economic performance.

Understanding the different exchange rate systems and how they function is essential for analyzing the global economy.