Fixed exchange rate system, Microeconomics


National currencies are generally acceptable within the geographical boundaries of a country. As such, trade between countries typically involves exchange of one country's currency for that of another. For example, if India were to import from the US, payments are to be made in US$. For making this international payment, India needs to earn the US$ (through exports) or buy the same from the foreign exchange market. How many Indian rupees need to be paid to purchase US$ depends on the value of dollar or exchange rate.

As you know, a rise (fall) in the external value of Rupee is called an appreciation (depreciation). For example, if the exchange rate between Rupee-US dollar is Rs.35/$ which changes to Rs 32/$, then the value of Rupee in terms of dollar has increased. Hence, Rupee has appreciated against the dollar. Conversely, had the exchange rate changed to Rs 38/$ then the value of Rupee in terms of dollar would have decreased. In this case, Rupee has depreciated against the dollar.

Assuming a simple situation where only two countries trade with one another, international transactions take place between two currencies. Exchange rate, in this situation, is determined by the demand for and supply of the two currencies. Because the exchange rate is expressed as the value of one currency in terms of another, when one currency appreciates, the other depreciates.

However, when a country has multiple trading partners, exchange rate between two currencies will also be influenced by the changes in the value of other currencies. For example, consider India's major trading partners to be the US, EU, Japan and China. The exchange rate between US$ and Indian rupee will not only be influenced by the

export and import flows between these two countries but also by the value of Euro, Yen and Yuan. If the exchange rate between US$ and Yen changes, this also will influence the exchange rate between US$ and Rupee. These dynamics of exchange rate changes are analyzed with appropriate exchange rate indices, namely, nominal effective exchange rate (NEER) index and real effective exchange rate (REER) index.

Exchange rate changes are also a function of the exchange rate regime followed by a country, which is of two types, viz., flexible and fixed exchange rates. When the exchange rate is determined by the equality between demand and supply for foreign currency, then we have flexible or floating exchange rate regime. When official intervention (by monetary authorities or government) is used to maintain the exchange rate at a particular value, then we have fixed or pegged exchange rate regime. Between these two regimes, there are many possible intermediate cases, such as, adjustable peg and managed float. 

Under the adjustable peg, governments maintain the par values for the exchange rates but explicitly identify the conditions under which the par value can change. In a managed float, the government seeks to have some stabilizing influence on the exchange rate but does not fix the exchange rate at a pre determined par value.

Posted Date: 11/10/2012 7:09:18 AM | Location : United States

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