Exchange Rate Policy Notes1

8/9/2019 Exchange Rate Policy Notes1

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.

Exchange Rate Policy


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. In finance, the exchange rates (also

known as the foreign-exchange

rate, forex rate or FX rate)between two currencies specifies howmuch one currency is worth in termsof the other .


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.

It is the value of a foreignnations currency in terms ofthe home nations currency.


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. If you are traveling to another

country, you need to "buy" the

local currency.

Just like theprice of any asset,the exchange rate is the price

at which you can buy thatcurrency.


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. The spot exchange rate refers to

the current exchange rate.

The forward exchange rate refersto an exchange rate that is quotedand traded today but for delivery andpayment on a specific future date.


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.

The exchange rate regime is the

way a country manages its currencyin respect to foreign currencies andthe foreign exchange market.


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.

It is closely related to monetary

policy and the two are generallydependent on many of the samefactors.


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. The basic types are a

floating exchange rate,where the market dictatesthe movements of the

exchange rate.


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. and the fixed exchange rate,

which ties the currency to

another currency, mostly morewidespread currencies such asthe U.S. dollar or the euro.


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Floating exchange rate

Afloating exchange rate or aflexible exchange rate is a type

ofexchange rate regimewherein a currency's value isallowed to fluctuate according

to the foreign exchangemarket.


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. A currency that uses a

floating exchange rate isknown as a floatingcurrency.

The opposite of a floatingexchange rate is a fixedexchange rate.


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Floating exchange rates arepreferable to fixed exchangerates.


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As floating exchange rates

automatically adjust, theyenable a country to --------

dampen (reduce or diminish)the

impact ofshocks & foreign businesscycles;


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. and prevent the possibility

of having a balance ofpayments (BOP) crisis.


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. In cases of extreme appreciation or

depreciation, a central bank will

normally intervene to stabilize thecurrency.

Thus, the exchange rate regimes offloating currencies may more

technically be known as a managedfloat.


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. When liabilities are denominated in

foreign currencies while assets are

in the local currency, unexpected depreciations of the

exchange rate deteriorate bank and

corporate balance sheets andthreaten the stability of thedomestic financial system.


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Fixed Exchange Rate

However, in certainsituations, fixed exchangerates may be preferable fortheir greater stability and

certainty.


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. Afixed exchange rate, sometimes

called a pegged exchange rate, is a

type ofexchange rate regime whereina currency's value is matched to thevalue of another single currency or toa basket of other currencies, or to

another measure of value, such asgold.


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. A fixed exchange rate is usually

used to stabilize the value of a

currency, vis-a-vis the currencyit is pegged (fixed) to.


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. This facilitates trade and

investments between the

two countries, and is especially useful for

small economies where

external trade forms a largepart of their GDP.


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. It is also used as a means

to control inflation.

However, as the referencevalue rises and falls, so

does the currency pegged(fixed) to it.


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. In addition, a fixed exchange

rate prevents a government

from using domestic monetarypolicy in order to achievemacroeconomic stability.


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. Typically, a government

wanting to maintain a fixedexchange rate does so--------------- by either buying or

selling its own currency onthe open market or


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. In order to maintain the local

exchange rate,

the central bank buys and sellsits own currency on the foreignexchange market in return for

the currency to which it ispegged.


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. This is one reason how

governments maintainreserves of foreigncurrencies.


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. If the exchange rate

drifts (flow or float) toofar below the desired rate,the government buys its

own currency off the marketusing its reserves.


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. This places greater

demand on the marketand pushes up the priceof the currency.


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. If the exchange rate

drifts too far above thedesired rate, the oppositemeasures are taken.


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Criticisms

The main criticism of a

fixed exchange rate isthat flexible exchange ratesserve to automaticallyadjust the balance of trade.


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. When a trade deficit

occurs, there will be

increased demand for theforeign (rather than

domestic) currency.


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. which will push up the

price of the foreign currency

in terms of the domesticcurrency.


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.

Under fixed exchange rates,

this automatic re-balancingdoes not occur.

Documents

Exchange Rate Policy Notes1