18.3 Exchange Rate Systems

Obviously, there is not one answer for all countries, or we would not see different exchange rate regimes today. With flexible rates, the foreign exchange market sets the exchange rate, and monetary policy is available to pursue other targets. On the other hand, fixed exchange rates require central bank intervention. Monetary policy is aimed at the exchange rate.The importance a country attaches to an independent monetary policy is one very important factor in the choice of an exchange rate regime. Another is the size and volatility of the international trade sector of the economy. A flexible exchange rate provides some automatic adjustment and stabilization in times of change in net exports or net capital flows.

Let’s try to understand the concept of exchange rate regime by using Figure 18.2. In this figure, suppose the exchange rate is fixed at [latex]\textit{er*}[/latex]. There would be a free market equilibrium at [latex]\text{A}[/latex] if the supply curve for U.S. dollars is [latex]\textit{S}_{1}[/latex] and the demand curve for U.S. dollars is [latex]\textit{D}_{1}[/latex]. The central bank does not need to buy or sell U.S. dollars. The market is in equilibrium and clears by itself at the fixed rate.

Suppose demand for U.S. dollars shifts from [latex]\textit{D}_{1}[/latex] to [latex]\textit{D}_{2}[/latex]. Canadians want to spend more time in Florida to escape the long, cold Canadian winter. They need more U.S. dollars to finance their expenditures in the United States. The free-market equilibrium would be at B, and the exchange rate would rise if the Bank of Canada takes no action.However, with the exchange rate fixed by policy at [latex]\textit{S}_{1}[/latex][latex]\textit{er*}[/latex] there is an excess demand for U.S. dollars equal to AC. To peg, or set, the exchange rate, the Bank of Canada sells U.S. dollars from the official exchange reserves in the amount [latex]\text{AC}[/latex].The supply of U.S. dollars on the market is then the “market” supply represented by [latex]\textit{S}_{1}[/latex] plus the amount [latex]\text{AC}[/latex] supplied by the Bank of Canada. The payment the Bank receives in Canadian dollars is the amount ([latex]\textit{er*}\times\text{AC}[/latex]), which reduces the monetary base by that amount. The lower monetary base pushes domestic interest rates up and attracts a larger net capital inflow. Higher interest rates also reduce domestic expenditure and the demand for imports and for foreign exchange. The exchange rate target drives the Bank’s monetary policy, which in turn changes both international capital flows and domestic income and expenditure.

What if the demand for U.S. dollars falls to [latex]\textit{D}_{3}[/latex]? The market equilibrium would be at [latex]\text{F}[/latex]. At the exchange rate at [latex]\textit{er*}[/latex] there is an excess supply of U.S. dollars [latex]\text{EA}[/latex]. To defend the currency peg, the Bank of Canada would have to buy [latex]\text{EA}[/latex] U.S. dollars, reducing the supply of U.S. dollars on the market to meet the “unofficial” demand. The Bank of Canada would have to buy [latex]\text{EA}[/latex] U.S. dollars, reducing the supply of U.S. dollars on the market to meet the “unofficial” demand. The Bank of Canada’s purchase would be added to foreign exchange reserves. The Bank would pay for these U.S. dollars by creating more monetary base, as in the case of an open market purchase of government securities.

In either case, maintaining a fixed exchange rate requires central bank intervention in the foreign currency market. The central bank’s monetary policy is expansionary because it is committed to the exchange rate target. When the demand schedule is [latex]\textit{D}_{2}[/latex], foreign exchange reserves are running down. When the demand schedule is [latex]\textit{D}_{3}[/latex], foreign exchange reserves are increasing. If the demand for U.S. dollars fluctuates between [latex]\textit{D}_{2}[/latex] and [latex]\textit{D}_{3}[/latex], the Bank of Canada can sustain and stabilize the exchange rate in the long run.

However, if the demand for U.S. dollars is, on average, [latex]\textit{D}_{2}[/latex], the foreign exchange reserves are steadily declining to support the exchange rate [latex]\textit{er*}[/latex], and the monetary base is falling as well. In this case, the Canadian dollar is overvalued at [latex]\textit{er*}[/latex]; or, in other words, [latex]\textit{er*}[/latex] is too low a price for the U.S. dollar. A higher [latex]\textit{er}[/latex] is required for long-run equilibrium in the foreign exchange market and the balance of payments. As reserves start to run out, the government may try to borrow foreign exchange reserves from other countries and the International Monetary Fund (IMF), an international body that exists primarily to lend to countries in short-term difficulties.

At best, this is only a temporary solution. Unless the demand for U.S. dollars decreases, or the supply increases in the longer term, it is necessary to devalue the Canadian dollar. If a fixed exchange rate is to be maintained, the official rate must be reset at a higher domestic currency price for foreign currency.

Real Cases

For many years frequent media and political discussions of the persistent rise in China’s foreign exchange holdings provide a good example of the defense of an undervalued currency. With the yuan at its current fixed rate relative to U.S. dollars and other currencies, China has a large current account surplus that is not offset by a financial account deficit. Balance of payments equilibrium requires ongoing intervention by the Chinese central bank to buy foreign exchange and add to official reserve holdings. Buying foreign exchange adds to the monetary base and money supply, raising concerns about inflation. The Bank has responded in part with a small revaluation of the yuan and in part with an increase in the reserve requirements for Chinese banks. Neither of these adjustments has been sufficient to change the situation fundamentally and growth in official foreign exchange reserves continues.

In Europe, the euro currency system effectively fixes exchange rates among member countries. Individual member countries do not have national monetary policies. Monetary policy is set by the European Central Bank. In the years following the “Great Recession,” this has been a source of controversy because economic and fiscal conditions have differed significantly among countries. Countries trying to adjust fiscal deficits and national public debt crises have been forced into fiscal austerity without offsetting monetary policy support. In many cases the results have been deep and prolonged recessions without solving their debt problems. Greece is the poster child.

Of course, it is not necessary to adopt the extreme regimes of pure or clean floating on the one hand and perfectly fixed exchange rates on the other hand. Dirty or managed floating is used to offset large and rapid shifts in supply or demand schedules in the short run. The intent is to smooth the adjustment as the exchange rate is gradually allowed to find its equilibrium level in response to longer-term changes.

Source: Adapted from 12.3: Flexible exchange rates and fixed exchange rates in Principles of Macroeconomics by D. Curtis & I. Irvine, licensed under CC BY-NC-SA.