Fixed & Managed Exchange Rates

Question 1

Understanding a fixed exchange rate system

Answer 1

Central bank buys & sells foreign currencies so its own currency’s value stays pegged to a major currency

Market forces of supply & demand are manipulated by central bank to fix the rate
- Markets causing currency to fall?
Need to reduce currency’s supply OR increase demand

Question 2

Fixed exchange rate

Answer 2

A nation’s currency’s value is fixed against either:
- Value of another nation’s currency
- Basket of other currencies
- Gold

It is easier to maintain rate if currency is too strong
- b/c requires selling domestic currency to buy foreign reserves

Question 3

How can gov’t intervene to maintain fixed exchange rates?

Answer 3

1. Use official reserves
   - Sell reserves to demand currency

• Drawbacks?
• Foreign reserves may be used up if depreciation persists

2. Increase interest rates to increase demand
   - ↑D from hot money investors

• Drawbacks?
• Contractionary monetary policy slows consumption & investment, more unemployed

3. Borrow Forex from abroad
   - Get foreign reserves to purchase domestic currency & ↑D

• Drawbacks?
• Have to repay later 🡪 reduces future PPC/growth

4. Limit imports
   - Reduce currency’s supply
   - Protectionism & fiscal policy

-Drawbacks?
-Retaliation, regressive policy, & resource misallocation

5. Foreign exchange controls
   - Limit currency exchange
   - Purpose is to reduce supply

• Drawbacks?
• Parallel black market for currency develops
• Resource misallocation b/c firms can’t buy capital goods

Question 4

Devaluation & Revaluation

Answer 4

Cheaper exports, more expensive imports

Increases net exports = good for domestic GDP

But, bad for competing countries economies, so other nations devalue their currency too

Currency wars!

Question 5

Managed exchange rates (managed float)

Answer 5

Purpose of central bank’s managing its exchange rate is to prevent rapid & significant fluctuations, promote stability

Allows for currency to freely float to market equilibrium over a long period of time

Targeted band of acceptable currency fluctuation
- Small fluctuations permitted w/out gov. intervention

Question 6

Pegging exchange rates

Answer 6

Some nations w/smaller economies fix the value of their currency to value of a major economy’s currency

Trade increases amongst countries w/shared currency peg

Greater stability, more investment = more growth

Question 7

Positives of an Overvalued Currency?

Answer 7

More common in LEDCs wanting to import capital goods to speed up rate of industrialization

Can be crucial for LEDCs where basic necessities (e.g. food, medicines, energy) have to be imported

-Pressures domestic firms to be efficient & cut costs
-Reduces inflation

Question 8

Drawbacks of an overvalued currency?

Answer 8

• Exporters less globally competitive ☹
• Neg. impact on competing domestic industries ☹

-Higher unemployment ☹

-Trade deficit ☹

Question 9

Overvalued currency

Answer 9

fixed/managed value is set too high relative to its free market equilibrium rate
Do not exist in free floating system

Question 10

Undervalued currency

Answer 10

fixed/managed value is too low relative to its free market rate

Question 11

Consequences undervalued currency

Answer 11

-Imports more expensive

-Cost-push inflation

-Demand-pull inflation

-“Cheating” in global competition w/unfair comparative advantage
-Invites retaliation from other states to devalue their currencies
-Creates conflict w/trade partners