In this video we’ll examine fixed exchange rates and see how they are managed.
You should have a basic understanding of exchange rates and understand how they are determined.
While you’re not explicitly asked to understand the advantages and disadvantages of exchange
rate systems, it is helpful to know.
I’ll make a couple of points regarding this in the presentation.
Fixed exchange rate systems occur when the government of a country fixes the value of
its currency to another currency, a basket of currencies or a commodity, such as gold.
I’ve put the image up of the Bahamas because many Caribbean islands peg, or fix, the value
of their currency against the American dollar because they are heavily dependent on the
US for tourism.
A government operating a fixed exchange rate regime will intervene in the foreign exchange
market or use the interest rate to influence the supply and demand for the currency.
We’ll define what happens when they aim to increase or decrease the value of the currency
in the next slide.
We’ll then look at how it’s done.
When discussing the revaluation or devaluation of currencies, we are generally referring
to fixed exchange rate regimes.
Revaluation occurs when a government intervenes to increase the value of its currency relative
to another.
If a country sets its exchange rate to 2 to 1 against the dollar and then allows it to
increase to 1 to 1, then we say that it has revalued.
Devaluation occurs when a government intervenes to decrease the value of its currency relative
to another.
If a country sets its exchange rate to 1 to 1 against the dollar and then allows it to
decrease to 2 to 1, then we say that it has devalued.
Next we’ll see how a government actively intervenes to keep the exchange rate fixed.
Although China no longer operates a fixed exchange rate regime, having moved over to
a managed float system, we can actually use the country’s currency history to help us
understand the two different exchange rate systems.
For this example, we will look at the period of time in which China fixed the value of
the yuan to the dollar at about 8.28 to the dollar.
This value held from 1994 to 2005.
How it’s changed since we will look at in the next video.
Imagine that the Chinese government wants to keep the value of the currency at ER* relative
to the dollar.
If $1 buys 8.28 yuan, then we know that 1 yuan = .1208 dollars or about 12.1 cents.
I arrived at this figure by dividing $1 by 8.28.
Suppose the demand for Chinese exports rises significantly and the yuan starts to strengthen
against the dollar.
This would make Chinese exports more expensive to American buyers and could potentially hurt
the export-led growth and development the Chinese government pursued during that time
frame.
So, in order to maintain stability in export markets, the Chinese government would intervene
by increasing the supply of yuan in the foreign exchange market.
This would decrease the value of the currency and it would return it to its original exchange
rate with the United States dollar.
The government essentially takes actions to offset any increase or decrease in the exchange
rate.
If it wants to decrease the exchange rate, it sells off its own currency or the central
bank takes action to decrease interest rates.
If it aims to increase the exchange rate, the government could buy its own currency,
limit how much can be exchanged in the foreign exchange market, or the central bank could
choose to increase interest rates.
The advantages of a fixed exchange rate system include the reduction in risk which is associated
with exchange rate fluctuations.
Firms know what exchange rate to expect when conducting business abroad and this can inform
more long-term decision making.
Also, with a fixed exchange rate system, currency speculation is limited.
If there is an expectation that the currency may be revalued or devalued, there’s still
the possibility of speculation.
However, a fixed exchange rate regime is far less prone to speculation than a floating
exchange rate system.
The disadvantages of operating a fixed exchange rate regime include a loss of flexibility
in responding to economic conditions.
If the government chooses to decrease interest rates to increase aggregate demand within
the economy, it must also consider the resulting impact on the exchange rate.
In order to manage the value of their currency, a government may have to hold foreign currency
reserves.
Since they must hold reserves, there is an associated opportunity cost in that these
reserves cannot be used for other purposes, such as investment.
If the central bank is changing interest rates to change the value of the exchange rate,
this will also have an impact on the domestic economy.
Changing interest rates also affect consumer and business behaviour by increasing the cost
of borrowing.
Hopefully you’ve got a better understanding of fixed exchange rates and fixed exchange
rate regimes.
If you have any questions, please leave them below or email me at enhancetuition@gmail.com.
You can also tweet me @enhancetuition and soon find me on my website enhancetuition.co.uk.
As always, thanks for watching and I will see you in the next one!