Floating exchange rates, Microeconomics

Floating exchange rates

There are two basic systems that can be used to determine the exchange rate between one country's currency and another's: a floating exchange rates (also called a flexible exchange rates) system and a fixed exchange rates system. Under a floating exchange rate system, the value of a country's currency is determined by the supply and demand for that currency in exchange for another in a private market operated by major international banks. In contrast, in a fixed exchange rate system a country's government announces, or decrees, what its currency will be worth in terms of "something else" and also sets up the "rules of exchange." The "something else" to which a currency value is set and the "rules of exchange" determines the type of fixed exchange rate system, of which there are many. For example, if the government sets its currency value in terms of a fixed weight of gold then we have a
gold standard. If the currency value is set to a fixed amount of another country's currency, then it is a reserve currency standard.
When a country has a regime of flexible exchange rates, it will allow the demand and supply of foreign currency in the exchange rate market to determine the equilibrium value of the exchange rate. So the exchange rate is market determined and its value changes at every moment in time depending on the demand and supply of currency in the market.

Some countries (for e.g. China, Mexico and many others), instead, do not allow the market to determine the value of their currency. Instead they "peg" the value of the foreign exchange rate to a fixed parity, a certain amount of rupees per dollar. In this case, we say that a country has a regime of fixed exchange rates. In order to maintain a fixed exchange rate, a country cannot just announce a fixed parity: it must also commit to defend that parity by being willing to buy (or sell) foreign reserves whenever the market demand for foreign currency is greater (or smaller) than the supply of foreign currency.

We have seen that banks are big players in the foreign exchange markets. Changes in flexible exchange rates are brought about by banks' attempts to regulate their inventories. However, these inventory changes reflect more basic underlying forces of demand and supply that come from the attempts of households, firms and financial institutions to buy and sell goods, services and assets across nations. Changes in exchange rates, in turn, modify the behaviour by households, firms and financial institutions. Under a fixed.

 

Posted Date: 11/9/2012 6:00:32 AM | Location : United States







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