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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

Ben Reply
what is the determination of aggregate demand?
Maddy Reply
classical dichotomy and its components?
Romaisa Reply
what will happen to the demand curve when there is an inflation in an economy
Hamza Reply
From my view, I think the demand curve will shift inwards.
now it depends on what kind of inflation it is, depending on the type of inflation the movement of the demand curve can be stated.
yes it depends on the cause for inflation. if it caused by maybe an increase in money supply, the effect is neutral in the long term, therefore there are no effects on total output in the economy, except for an increase in price
but short term in general i think you could expect the demand curve to shift inwards as consumers experience a decrease in real income
source of capital for the sole trader
Dogbey Reply
borrowing from relatives, government grants, bank loans, personal savings, credit card etc.
Suppose you are holding 2000 in a checking account and the price level decrease by 20 %how much it will affect your purchasing power and why
Iqra Reply
Hi Iqra, will answer your question soon.
2000*0.2= 400 2000-400= 1600
a price level decrease is deflation. it means you'll be able to afford to buy more with your 2000 and your real income becomes 2000÷(100-20)=2500
the amount will decrease to 1600 and you can't be able to buy over this amount
As an economist student discuss how the pandemic covid19 can affect the aggregate demand and aggregate supply thereby leading to decrease in GDP and standard of living of citizens of nigeria
Fadila Reply
hi how can you help me?
qusai Reply
can you send me the notes
hello is what are you talking about?
unemployment and low inflation    .
Abdirizaq Reply
Structure/Organization Of The Federal Reserve
sorry guys in macroeconomics what is different between inflation and intrest rate? please example for pandemic related maybe?
Is this Aap for class 11 and 12 only not for graduation?
ankit Reply
yeah like for du MA entrance
Aree i m also asking
for du MA entrance. u shouldn't rely on app. Go for SAURABH SIR notes. available on flipkart.
ohh thanks
what is inflation
Bright Reply
hike in price
situation of rise in price with the fall in purchasing power of money
cycle of corruption
rise in price of a Nation economy in terms of trade
what is distruptive international trade?
meaning of inflation
Jayakumar Reply
increase in general prices level in an economy.
increase in general price level
The fall in standard of living because goods and services become expensive.
what is value added and how is it used in calculating GDP
Benedicta Reply
value added is final price of output minus cost of production. For example, let's say you make a shirt with raw materials that cost $20, and then sell the shirt for $35 added value would be 35-20=15. In calculating GDP, it is used to avoid double counting goods. Exp. eggs individually and in bread.
as the price of tickets rises from $200 to $250, what is the price elasticity of demand for business travelers, vacationers using midpoint method
Buumba Reply
@jb how do uget $300
It means you are measuring the cost against availability.
Explain how income taxes and transfer payments are used to stabilize the economy
Nakagwa Reply
reduce demand on scarce resources by reducing money supply.

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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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