Currency exchange rates are commonly subject to government control through three exchange rate policies -- flexible exchange rate, fixed exchange rate, and managed flexible exchange. These policies are designed generally to affect international trade among countries, as well as the balance of trade and balance of payments of particular countries.
Exchange rates are the price of one nation's currency in terms of another nation's currency, or the rate at which one currency is traded for another. For example, an exchange rate of two U.S. dollars per British pound means that the price of a British pound is two dollars.
Exchange rates are key to international trade, exports and imports flowing among countries. First and foremost, the trading of goods and services requires the exchange of currencies. When buyers in the United States purchase goods from England, they need ultimately need British pounds to complete the transaction. However, the resulting exchange rate also affects exports and imports, which is where exchange rate policies come into play.
Controlling RatesAn exchange rate reflects the value of one currency relative to another. All things considered, if one country has twice as much currency in circulation as another, then each unit of that currency is worth half as much. As such, the primary way to control exchange rates is to control the quantity of money in circulation.
If the United States, for example, wants to increase the exchange rate for British pounds from 2 dollars per pound to 3 dollars per pound, it can do so by increasing the quantity of U.S. dollars in circulation. With more U.S. dollars, the value of each is less and more are needed to purchase one British pound. Of course, a decrease in the exchange rate, say from 2 dollars per pound to 1 dollar per pound, can be had by decreasing the quantity of U.S. dollars in circulation. The same results can also be obtained with opposite changes in the quantity of British pounds in circulation.
However, rather than an economy-wide money supply change, the change is usually targeted at a particular exchange rate. The United States government, for example, can change the dollar-pound exchange rate by buying or selling British pounds in the dollar-pound foreign exchange market. In so doing, the quantity of dollars either increases (when buying pounds) or decreases (when selling pounds).
Like other government policies actions, exchange rate controls have secondary consequences. Changes in the money supply are bound to affect the performance and stability of domestic economy, especially the inflation rate.
Flexible Exchange RateThe first of three policy options is a flexible exchange rate, which is essentially a policy of letting the foreign exchange market adjust to equilibrium in response to changes in demand or supply. A flexible exchange rate, also termed floating exchange rate, is an exchange rate determined through the unrestricted interaction of supply and demand in the foreign exchange market.
A flexible exchange rate means that a country is NOT trying to manipulate currency prices to achieve some change in the exports or imports. This policy is based on the presumption that the free interplay of market forces is most likely to generate a desireable pattern of international trade. However, if a desireable pattern is not achieved, then tariffs, import quotas, or other trade policies might be enacted. It also provides a benchmark for the analysis of other policies.
Fixed Exchange RateThe second of three policy options, a fixed exchange rate, is in direct contrast to a flexible exchange rate. This is a policy of setting the foreign exchange rate at a given level. A fixed exchange rate is an exchange rate that is established at a specific level and maintained through government actions (usually through monetary policy actions of the central bank).
To fix an exchange rate, government must be willing to buy and sell currency in the foreign exchange market in whatever amounts are necessary to keep the exchange rate fixed at a specified level. A fixed exchange rate typically disrupts the flow of trade, the balance of trade, and the balance of payments for a country. But in many cases, this is exactly what a country is seeking to do.
Setting the exchange rate at a low level, below the flexible exchange rate, encourages exports and discourages imports, which increases net exports. Setting the exchange rate at a high level, in contrast, discourages exports and encourages imports, which decreases net exports. Moving from a higher to lower exchange rate is termed devaluation or depreciation of currency. Moving from a lower to higher exchange rate is termed revaluation or appreciation of currency.
Managed Flexible Exchange RateThe third policy option combines flexible and fixed exchange rates and is termed a managed flexible exchange rate, or managed float. A managed flexible exchange rate, or managed float, is an exchange rate that is generally allowed to adjust due to the interaction of supply and demand in the foreign exchange market, but with occasional intervention by government.
Most nations of the world currently use a managed flexible exchange rate policy. With this alternative an exchange rate is free to rise and fall, but it is subject to government control if it moves too high or too low. With managed float, the government steps into the foreign exchange market and buys or and sells whatever currency is necessary keep the exchange rate within desired limits.
The logic behind this policy is that an unrestricted movement in an exchange rate is generally beneficial, but serious problems in the balance of payments and balance of trade can occur if it changes too far in either direction.
EXCHANGE RATE POLICIES, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: February 25, 2018].