Exchange rates in a fixed exchange rate system Fixed exchange rates A fixed exchange rate system is one in which exchange rates are fixed by the Central Bank of each country, and are not permitted to change in response to changes in the supply and demand for currencies. How do you think a Central Bank can make this happen? Fixed exchange rates A country’s Central Bank continuously buys and sells currencies held in reserve to maintain the value of the currency at the fixed rate. It may also make other adjustments within the domestic economy. Both practices aim to shift the demand and supply curves in order to eliminate the disequilibrium in the foreign exchange market Central Bank Intervention Assume a country experiences a decrease in the demand for it’s exports. What will happen to the demand for that country’s currency? Under a floating exchange system, a new equilibrium rate for the currency would be established. Would it be higher or lower? Because we have a fixed exchange rate policy, the Central Bank must act in order to maintain the original exchange rate Central Bank Intervention In the previous example, the country is experiencing an excess supply of its currency due to the reduced demand for its exports. In order to correct this imbalance, the Central Bank will use foreign currency reserves to purchase the excess supply of its currency so the original exchange rate is maintained. If demand for the country’s exports increased, the Central Bank would correct the problem by selling its currency and buy a different currency to correct the problem of excess demand Central Bank Intervention If there is a long-term downward pressure on the country’s currency, it may run out of reserve currency and lose the ability to maintain the fixed exchange rate. This won’t happen when there is excess demand for the country’s currency, because it can always sell its own currency for a foreign currency. So what happens when there is continued decreased demand for the country’s currency? How can the fixed exchange rate be maintained? Idea #1—Limit Imports If government enacts policies to limit imports, this will reduce the amount of their currency supplied (because residents won’t be exchanging the domestic currency for a foreign currency). This will shift the supply curve to the left and keep the exchange rate at the fixed level Government can limit imports in two different ways, can you name them? How government can limit Imports 1—Contractionary fiscal policy or monetary policy will reduce Aggregate Demand, lower incomes and therefore have the affect of reducing purchases of imported goods 2—Protectionist policies such as tariffs, quotas, voluntary export restraints and subsidies can limit the amount of imported goods entering the country Manipulating interest rates Another tool government has to maintain an official exchange rate is to increase interest rates. Higher interest rates should attract foreign investment, thus creating additional demand for the currency which will shift the demand curve for the currency to the right Imposing exchange controls Exchange controls restrict the amount of foreign currency that a country’s residents can purchase. By limiting purchases of foreign currency, the domestic currency will not flow out of the country. Therefore the domestic currency will strengthen If all else fails….. If the country is finding it too difficult to maintain the fixed exchange rate, they can always create a new rate of exchange. If the currency has a higher value than can be maintained through government intervention, the currency may be devalued. Conversely, if the currency has a lower value than can be maintained through government intervention, the currency may be revalued. Effects of Devaluation Devaluation has a direct effect on imports and exports. The newly valued currency has been depreciated, so residents are less able to import goods, but domestic firms will find it easier to export their products. This should lead to an increase in capital inflows to the country Managed float Managed exchange rates (or managed float) is a system that lies between floating and fixed exchange rates. This has been the type of exchange rate system used in the world since 1973. It is much closer to the floating exchange system, but it does allow governments to make adjustments for stabilization purposes. Managed float Typically, currencies under this system are flexible and changing on a daily basis. However, in order to prevent extreme fluctuations in a given currency which could disrupt world trade and create economic uncertainties, central banks do intervene occasionally to keep their currency close to its long-term equilibrium position Managed float The “managed” part of this exchange rate system takes place under similar tools as we talked about before, such as: Buying and selling currencies Manipulating interest rates Contractionary policies Protectionism Pegged exchange rates Developing countries will occasionally peg their currencies to the US dollar or the Euro and allow their currency to float together with it. A narrow range of acceptable values is established for the currency within which it can fluctuate. If the currency begins to approach the limit of the range, the central bank will intervene to keep the currency within it’s range. Pegged exchange rates..best of both worlds? Pegged currencies are fixed to the value of the dollar or euro and therefore trade within a narrow range, but they do float in relation to all other currencies. This system has several advantages: It helps stabilize the country’s currency in relation to the currency it is pegged to It creates exchange rate stability with other currencies It facilitates trade with the country it is pegged to and other countries that are pegged to the same currency Overvalued and undervalued currencies Overvalued currencies have an exchange rate that has been set at a higher value than the equilibrium exchange rate. Undervalued currencies have an exchange rate that has been set at a lower value than the equilibrium exchange rate. This does not happen when exchange rates are free to float, but does happen in the fixed or managed float system. Overvalued currencies Why would a country purposely overvalue its currency? Overvalued currencies When a country has an overvalued currency, it creates an opportunity to buy imported goods. Developing countries may overvalue their currencies so they can buy valuable capital goods and raw materials to kick start their manufacturing sectors. Unfortunately, an overvalued currency makes your country’s exports more expensive, creates a negative trade balance, and could lead to high unemployment rates Eventually, developing countries have to devalue at some point to correct these problems Undervalued currencies Undervalued currencies create a situation where the country’s exports are inexpensive but imports are costly. Developing countries looking to increase their market share globally may undervalue their currency in order to increase employment levels . Countries that undervalue their currencies create an unfair comparative advantage, which can be considered cheating or engaging in a “dirty float”.