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Comparing different methods governments use to manage their currency values.
Why does a dollar buy more in some years than others? Imagine you are a CEO deciding where to build a billion-dollar factory—how do you protect your investment if a currency's value could vanish overnight?
In the global economy, an exchange rate is simply the price of one currency in terms of another. Governments choose how this price is determined using three main systems. In a Floating Exchange Rate system, the value is determined solely by market forces of supply and demand. Conversely, a Fixed (Pegged) Exchange Rate occurs when a government ties its currency value to another major currency (like the USD) or a commodity (like gold). Between these lies the Managed Float, where the exchange rate is primarily market-driven, but the central bank intervenes to prevent extreme volatility. Understanding these systems is crucial because they dictate a nation's ability to conduct independent monetary policy.
Quick Check
In which system does the market have the most control over the currency's value?
Answer
The Floating Exchange Rate system.
Why do people want a specific currency? Two primary factors are Interest Rates () and Inflation (). High domestic interest rates attract foreign investors seeking better returns on savings. This influx of 'hot money' increases the demand for the currency, leading to Appreciation. On the other hand, high inflation erodes purchasing power. If a country's inflation rate is significantly higher than its neighbors, its goods become more expensive, exports fall, and the currency's value likely drops, known as Depreciation. We can model the relationship between the exchange rate () and these variables as a function of relative returns and purchasing power parity.
Suppose the UK increases its interest rate from to , while the US keeps its rate at . 1. Global investors seek the higher return. 2. To buy UK bonds, they must first buy British Pounds (GBP). 3. The demand curve for GBP shifts to the right. 4. The price (exchange rate) of the GBP increases relative to the USD.
Quick Check
If a country experiences a sudden spike in inflation, what is the likely immediate effect on its currency value?
Answer
The currency will likely depreciate because its purchasing power is falling and its exports become less competitive.
Central banks don't just watch from the sidelines. To influence the exchange rate, they use Foreign Exchange Reserves. If a currency is depreciating too quickly, the bank sells foreign reserves (like USD) and buys its own currency to boost demand. However, they face the Mundell-Fleming 'Impossible Trinity'. This theory states that a country cannot simultaneously have: 1. A fixed exchange rate, 2. Free capital movement, and 3. An independent monetary policy. A nation must pick two. For example, if you fix your exchange rate and allow capital to flow freely, you lose the ability to set your own interest rates because they must be adjusted solely to maintain the peg.
Imagine Country A pegs its currency at with the USD. Suddenly, investors lose confidence and start selling Country A's currency. 1. The supply of Country A's currency in the market increases, putting downward pressure on the price. 2. To maintain the peg, Country A's central bank must buy its own currency using its USD reserves. 3. If Country A runs out of USD reserves, it will be forced to devalue its currency, breaking the peg.
Consider a country that wants to stimulate its economy by lowering interest rates () while maintaining a fixed exchange rate and open borders for capital. 1. Lower causes investors to move money out of the country to find higher returns elsewhere. 2. This capital flight increases the supply of the domestic currency on the FX market. 3. To keep the exchange rate fixed, the central bank must buy that excess supply using foreign reserves. 4. Eventually, reserves will be exhausted. Therefore, the country must either let the exchange rate float or restrict capital from leaving (capital controls).
Which term describes a deliberate downward adjustment of a currency's value by a government in a fixed system?
According to the Impossible Trinity, if a country chooses to have a fixed exchange rate and an independent monetary policy, what must it give up?
A central bank can defend a depreciating currency indefinitely as long as they can print more of their own domestic currency.
Review Tomorrow
In 24 hours, try to sketch the 'Impossible Trinity' triangle and explain why you can only choose two sides.
Practice Activity
Look up the current exchange rate between the USD and the Chinese Yuan (CNY). Research whether the Yuan is considered a floating or a managed currency.