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By the end of this section, you will be able to:

  • Differentiate among a floating exchange rate, a soft peg, a hard peg, and a merged currency
  • Identify the tradeoffs that come with a floating exchange rate, a soft peg, a hard peg, and a merged currency

Exchange rate policies come in a range of different forms listed in [link] : let the foreign exchange market determine the exchange rate; let the market set the value of the exchange rate most of the time, but have the central bank sometimes intervene to prevent fluctuations that seem too large; have the central bank guarantee a specific exchange rate; or share a currency with other countries. Let’s discuss each type of exchange rate policy and its tradeoffs.

A spectrum of exchange rate policies

The graph shows several options of exchange rate policies.
A nation may adopt one of a variety of exchange rate regimes, from floating rates in which the foreign exchange market determines the rates to pegged rates where governments intervene to manage the value of the exchange rate, to a common currency where the nation adopts the currency of another country or group of countries.

Floating exchange rates

A policy which allows the foreign exchange market to set exchange rates is referred to as a floating exchange rate    . The U.S. dollar is a floating exchange rate, as are the currencies of about 40% of the countries in the world economy. The major concern with this policy is that exchange rates can move a great deal in a short time.

Consider the U.S. exchange rate expressed in terms of another fairly stable currency, the Japanese yen, as shown in [link] . On January 1, 2002, the exchange rate was 133 yen/dollar. On January 1, 2005, it was 103 yen/dollar. On June 1, 2007, it was 122 yen/dollar, on January 1, 2012, it was 77 yen per dollar, and on March 1, 2015, it was 120 yen per dollar. As investor sentiment swings back and forth, driving exchange rates up and down, exporters, importers, and banks involved in international lending are all affected. At worst, large movements in exchange rates can drive companies into bankruptcy or trigger a nationwide banking collapse. But even in the moderate case of the yen/dollar exchange rate, these movements of roughly 30 percent back and forth impose stress on both economies as firms must alter their export and import plans to take the new exchange rates into account. Especially in smaller countries where international trade is a relatively large share of GDP, exchange rate movements can rattle their economies.

U.s. dollar exchange rate in japanese yen

The graph shows how the U.S. dollar as compared to the Chinese yen since 2001. The line's variations represent the volatility of exchange rates.
Even seemingly stable exchange rates such as the Japanese Yen to the U.S. Dollar can vary when closely looked at over time. This figure shows a relatively stable rate between 2011 and 2013. In 2013, there was a drastic depreciation of the Yen (relative to the U.S. Dollar) by about 14% and again at the end of the year in 2014 also by about 14%. (Source: Federal Reserve Economic Data (FRED) https://research.stlouisfed.org/fred2/series/DEXJPUS)

However, movements of floating exchange rates have advantages, too. After all, prices of goods and services rise and fall throughout a market economy, as demand and supply shift. If an economy experiences strong inflows or outflows of international financial capital, or has relatively high inflation, or if it experiences strong productivity growth so that purchasing power changes relative to other economies, then it makes economic sense for the exchange rate to shift as well.

Questions & Answers

which model predicted a global collapse in the world's social and economic system before the year 2010
Francis Reply
what is the formula of mixed income ?
Sanjum Reply
labor force in.Nigeria is seen as .......?
Aisha Reply
Is demand the same as being in need of a product?
Aphiwe Reply
yeah
Demand is defer from only need of products
Zubairu
need is the primary and main root of demand. but demand is the result of combination of need; income capacity and desire to expend of money for that product.
Ramu
products or services
jax
what is price determination?
Alick Reply
why are imports subtructed when GDP is calculated in the expenditure approach
nati
what is fiscalpolicy
nati Reply
The way of the government expenses and other analysis
Zubairu
It explains government spending and how it helps to direct the economy towards the desired direction. For instance, if the govt of a nation is desirous of achieving economic growth and development, then the govt will adopt an expansionary fiscal policy which imply more spending by the govt.
Sunday
and politics party important
mujtaba Reply
politics party important
mujtaba
Which party is that
Zubairu
persons who stopped searching for jobs but would accept if the opportunity presents itself
Torissa Reply
persons who are unemployed whether they are underage, retired or incapacitated
Torissa
the us economy is best characterized as?
Shekeriah
what is the impact of fiscal policy in the short and long run in the AD/AS model...
Hydrammeh Reply
What is demand
Mohd Reply
Demand is the desire for a commodity backed by the willingness and the purchasing power too.
Ajay
what is the impact of the higher tax rate on the business and the economy at large..?
Hydrammeh Reply
aggregate demand decreases and GDP decreases in the long run prices will decrease because aggregate supply will shift to the right and increase
Murabit
Thanks, Murabit
Hydrammeh
But still I will need more explanation
Hydrammeh
no problem tax rate is a form of fiscal policy so any time the government changes spending or taxes it will directly affect the economy
Murabit
but remember that there at different economic views on fiscal policy there is classical,Keynesian and moneterism
Murabit
if taxes increase aggregate demand decreases causing a fall in prices causing a fall in the money demand lowering interest rate and increasing investment spending in turn increasing prices
Murabit
thanks so much Murabit
Hydrammeh
what are the policy recommendations for impact of government borrowing?
Baisiro Reply
how can I get Utility notes here
Tabea Reply
I also want to know
konglan
I have them
Alick
money and money supply
Yogesh Reply
money is anything that is generally accepted as payment of goods and services or that is accepted in settlement of debt.
Rakgadi
Money supply?
Rakgadi
Money supply is the total value of monetary assets available in an economy at a specific time.
Rakgadi
supply of money:- The total quantity of money in an economy at a point of time......
Ittoo
What is the difference between monetary economy and barter economy?
Rakgadi
monetary economy is simply an economy where money acts as a medium of exchange and barter economy is why where goods acts as a medium of exchange
Ittoo
Thank you Ittoo.
Rakgadi
please cut why.....in last ans
Ittoo
and no need of thanks dear
Ittoo
Don't damend work in inflation
Mishael Reply

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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