1. EXCHANGE RATE
POLICY
MODULE 43

2. DOLLAR-YEN MARKET
The nominal exchange rate is
determined by supply and demand.
It is the price of a country’s money in
terms of another country’s money.
Money is an asset whose quantity is
determined by government policy.

3. DOLLAR-YEN MARKET
The exchange rate determines the price
of imports and of exports.
This can have major effects on
aggregate output and the aggregate
price level.
Governments can adopt a variety of
exchange rate regimes.

4. EXCHANGE RATE REGIMES
 An exchange rate regime is a rule
governing policy toward the exchange
rate.
 There are two main kinds of exchange
rate regimes:
1. Fixed exchange rate: when the
government keeps the exchange rate
against some other currency at or near a
particular target (Hong Kong keeps an
exchange rate of HK$7.80 per US$1)

5. EXCHANGE RATE REGIMES
2. Floating exchange rate: when the
government lets the exchange rate
fluctuate wherever the market takes it
(this is the regime followed by the U.S.,
Britain, and Canada).
 Countries can adopt compromise
policies that lie somewhere between
fixed and floating exchange rates.

6. EXCHANGE RATE REGIMES
 Countries can have exchange rates that
are fixed at any given time, but are
adjusted frequently, exchange rates that
are fixed at any given time but are
adjusted frequently, exchange rates that
aren’t fixed but are “managed” by the
government to avoid wide swings, and
exchange rates that float within a
“targeted zone”.

7. HOW CAN AN EXCHANGE RATE
BE HELD FIXED?
 When the exchange rate of a currency is
below the target exchange rate, there are 3
ways the government can support the value of
the currency to keep the rate where it wants it:
1. The government can “soak up” the surplus by
buying its own currency in the foreign
exchange market. This is called exchange
market intervention. In order to do this, the
government maintains foreign exchange
reserves, which are stocks or foreign
currency that they can use to buy their own
currency to support its price.

8. HOW CAN AN EXCHANGE RATE
BE HELD FIXED?
 An important part of international trade
flows is the purchases and sales of
foreign assets by governments and
central banks.
 Government sell foreign assets because
they are supporting their currency
through exchange market intervention.

9. HOW CAN AN EXCHANGE RATE
BE HELD FIXED?
2. Another way for a government to support its currency
is to try to shift the supply and demand curves for the
currency in the foreign exchange market.
Governments usually do this by changing monetary
policy, raising the interest rate to increase capital
flows into the country, and increasing demand for its
currency. This will also reduce the capital flows out of
the country, reducing the supply of the currency.
 Therefore, other things equal, and increase in a
country’s interest rate will increase the value of its
currency.

10. HOW CAN AN EXCHANGE RATE
BE HELD FIXED?
3. Third, the government can support the
currency by reducing its supply to the foreign
exchange market. It can do this by requiring
domestic residents who want to buy foreign
currency to get a licence, and giving these
licenses only to people with engaging in
approved transactions (such as importing
essential goods).
 Licensing systems that limit the right of
individuals to buy foreign currency are called
foreign exchange controls.
 Other things equal, foreign exchange controls
increase the value of a country’s currency.

11. HOW CAN AN EXCHANGE RATE
BE HELD FIXED?
 If the equilibrium value of a currency is
above the target rate, and there is a
shortage of the currency:
To maintain the target exchange rate the
government can:

12. HOW CAN AN EXCHANGE RATE
BE HELD FIXED?
1. It can intervene in the foreign exchange
market, by selling its currency and
buying foreign currency, which will be
added to its foreign exchange reserves.
2. It can reduce the interest rates to
increase the supply of its currency, and
reduce the demand.

13. HOW CAN AN EXCHANGE RATE
BE HELD FIXED?
3. The government can impose foreign
exchange controls that limit the ability
of foreigners to buy the currency.
All of these actions, other things equal,
will reduce the value of the currency.
The choice of exchange rate regime
poses a dilemma for policy makers
because fixed and floating exchange
rates each have advantages and
disadvantages.

14. HOW CAN AN EXCHANGE RATE
BE HELD FIXED?
The choice of exchange rate regime
poses a dilemma for policy makers
because fixed and floating exchange
rates each have advantages and
disadvantages.

15. ADVANTAGES OF FIXED EXCHANGE
RATES
1. One benefit of a fixed exchange rate is
the certainty about the future value of a
currency.
2. Adopting a fixed exchange rate also
means that a country is committing
itself not to engage in inflationary
policies, because these policies would
destabilize the exchange rate.

16. DISADVANTAGES OF FIXED
EXCHANGE RATES
1. To stabilize an exchange rate through
intervention, a country must keep large
quantities of foreign currency on hand,
and this currency is usually a low-return
investment.
2. Even large reserves can be quickly
exhausted when there are large capital
flows out of the country.

17. DISADVANTAGES OF FIXED
EXCHANGE RATES
3. If a country chooses to stabilize an exchange
rate by adjusting monetary policy, it must
divert monetary policy away from other goals,
such as stabilizing the economy and
managing the rate of inflation.
4. Foreign exchange controls, such as import
quotas and tariffs, distort incentives for
importing and exporting goods and services.,
and also may create substantial costs in
terms of red tape and corruption.

18. DILEMMA WITH EXCHANGE RATES
So the options are:
1. Let the currency float, which leaves monetary
policy available for macroeconomic
stabilization, but creates uncertainty for
everyone affected by trade, or
2. Fix the exchange rate, which eliminates trade
uncertainty, but means giving up monetary
policy, adopting exchange controls, or both.