1
EXCHANGE RATES
Exchange rates are extremely important for a trading economy such as the UK. There are several
reasons for this, including:
1. Exchange rates represent a cost to firms, which arises when commission is paid on the
exchange of one currency for another.
2. Exchange rate changes create a risk to those firms that hold assets in currencies other than
Sterling.
3. Exchange rates affect the price of exports, which form a significant part of aggregate
demand, and the price of imports, and hence the balance of payments.
Exchange rate regimes
An exchange rate regime is a system for determining exchange rates for specific countries, for a
region, or for the global economy. Throughout history, three basic regimes have existed:
Floating
A floating regime is one where currencies are allowed to move freely up and down according to
changes in demand and supply.
Fixed
Fixed rates are currency values which are tied to a precious metal such as gold, or anchored to
another currency, like the US Dollar.
Managed
Managed exchange rates exist when a currency partly floats and is partly fixed, such as happened
between 1990 and 1992, when Sterling was managed in the Exchange Rate Mechanism (ERM) of
the European Monetary System. This system preceded the European Euro (€), which was launched
in 1999.
1. Floating/Flexible exchange rates
Under a floating system a currency can rise or fall due to changes in demand or supply of currencies
on the foreign exchange market.
Changes in exchange rates
Changes in the exchange rate in a floating system reflect changes in demand and supply of
currencies. On a demand and supply diagram, the price of a currency such as Sterling (£) is
expressed in terms of the other currency, such as the USD ($).
Salman Azam Joiya
Economist
2
An increase in the exchange rate
For example, an increase in UK exports to the USA will shift the demand curve for Sterling to the
right and push up the exchange rate of the pound against the US dollar
Changes in interest rates
Changes in interest rates affect a country’s currency. Higher interest rates lead to an increase in
the demand for a country’s financial assets, and an increase in the demand for a currency.
Lower interest rates reduce speculative demand for assets and reduce demand for a currency. These
speculative flows are called hot money.
Increases in supply of a currency
An increase in the supply of a currency will depress its price. This could result from and increase
in imports relative to exports, or speculative selling of the currency.
Salman Azam Joiya
Economist
3
Equilibrium exchange rates
An ‘equilibrium’ exchange rate is the specific rate where export revenue and import spending are
equal.
Equilibrium
At currency ‘£’, import spending equals export revenue, at ‘Q’. At a higher rate, say at £ 1 imports
now appear cheap in the UK, and spending increases to Q m, and exports appear expensive abroad,
and fall to Qx. This opens up a trade gap (Qx to Qm).
Salman Azam Joiya
Economist
4
Those in favour of a floating exchange rate regime argue that allowing exchange rates to float will
enable trade to balance more quickly.
2. Fixed exchange rates
The IMF system
A fixed exchange rate regime involved currencies being fixed against a precious metal or against
another currency, or basket of currencies.
The International Monetary Fund (IMF) was conceived in 1944, at Bretton Woods, New
Hampshire (USA) and became operational in 1945. Its aim was to stabilise the world economy
through a system of fixed exchange rates. The IMF was one of three pillars to support the
development of post-war economies, the other two being GATT (The General Agreement on
Tariffs and Trade), later to become the WTO (World Trade Organisation), and the International
Bank for Reconstruction and Development, later to be called the World Bank.
The IMF system involved the US$ as the anchor for the system with the US$ given a specific value
in terms of gold, and other currencies were then given a value in terms of the US$, such as £1 =
$2.40c.
However, the system collapsed in 1971 for a number of reasons, including the build up of US debts
abroad as a result of the need to fund the war in Vietnam. In addition, inflation in the USA and
growing doubts about the stability of the US$ caused intense speculative activity against the US$.
Speculators frantically sold US$s during 1971 until President Nixon, took the US out of the system.
Salman Azam Joiya
Economist
5
3. Managed regimes
Managed regimes involve a mixture of free-market forces and intervention.
A recent example is the European Exchange Rate Mechanism (ERM), which operated from 1979
to 1999.
In this system, currencies were kept inside an agreed band of (+/-) 2.25% for most members. This
was achieved by the monetary authorities either raising or lowering interest rates, or by buying or
selling currency.
Exchange controls
Some currencies are subject to exchange controls, which mean that the relevant Central Bank will
only allow buying and selling through its own system, rather than be subject to fluctuations
associated with fully floating rates. Although most countries abandoned these controls many years
ago, some, like China and Cuba, still practice very strict exchange rate control.
Advantages of floating exchange rates
Flexibility and automatic adjustment
Over time, an economy may experience changes in imports and exports, and this can lead to a
balance of payments disequilibrium (deficit or surplus). Under a floating regime, the deficits and
surpluses will lead to adjustments in the exchange rate, which alter relative import and export
prices in the future. Therefore, imports and exports can readjust to move the balance of payments
back towards a desirable equilibrium. Exogenous shocks, like the financial crisis of 2008-09, can
occur from time to time and floating exchange rates can help the readjustment process.
Freedom
Policymakers are free to devalue or revalue to achieve specific objectives, such as stimulating jobs
and growth and reducing inflationary pressure.
Advantages of fixed regimes
Stability for firms
Exporting firm’s prices are more stable, as are importing firm’s costs. This is the main reason the
Chinese Yuan has been fixed against the US Dollar for nearly 20 years, creating a very stable
framework for Chinese manufacturing.
Predictability and confidence
Firms can plan ahead and are likely to invest more. Confidence is a necessary condition for
investment.
Salman Azam Joiya
Economist
6
Discipline
Another advantage of fixed exchange rates is that policy makers cannot devalue the currency in an
attempt to hide inflation or a balance of payments deficit. Deliberately holding a currency down
would reduce export prices abroad and nullify any domestic inflation, as well as providing a boost
to exports. In addition, policy makers cannot revalue to keep a currency artificially high to reduce
imported cost-push inflation.
Floating Rate vs. Fixed Rate: An Overview
More than $5 trillion is traded in the currency markets on a daily basis, as of 2018. An exchange
rate is the rate at which one currency can be exchanged for another. In other words, it is the value
of another country's currency compared to that of your own. If you are traveling to another country,
you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price
at which you can buy that currency.
If you are traveling to Egypt, for example, and the exchange rate for U.S. dollars is 1:5.5 Egyptian
pounds, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds.
Theoretically, identical assets should sell at the same price in different countries, because the
exchange rate must maintain the inherent value of one currency against the other.
Floating Rates
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply
and demand. A floating rate is often termed "self-correcting," as any differences in supply and
demand will automatically be corrected in the market. Look at this simplified model: if demand
for a currency is low, its value will decrease, thus making imported goods more expensive and
stimulating demand for local goods and services. This, in turn, will generate more jobs, causing an
auto-correction in the market. A floating exchange rate is constantly changing.
In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also
influence changes in the exchange rate. Sometimes, when a local currency reflects its true value
against its pegged currency, a "black market" (which is more reflective of actual supply and
demand) may develop. A central bank will often then be forced to revalue or devalue the official
rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.
In a floating regime, the central bank may also intervene when it is necessary to ensure stability
and to avoid inflation. However, it is less often that the central bank of a floating regime will
interfere.
Fixed Rate
A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official
exchange rate. A set price will be determined against a major world currency (usually the U.S.
dollar, but also other major currencies such as the euro, the yen, or a basket of currencies). In order
Salman Azam Joiya
Economist
7
to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign
exchange market in return for the currency to which it is pegged.
If, for example, it is determined that the value of a single unit of local currency is equal to US$3,
the central bank will have to ensure that it can supply the market with those dollars. In order to
maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved
amount of foreign currency held by the central bank that it can use to release (or absorb) extra
funds into (or out of) the market. This ensures an appropriate money supply, appropriate
fluctuations in the market (inflation/deflation) and ultimately, the exchange rate. The central bank
can also adjust the official exchange rate when necessary.
Special Considerations
Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold,
meaning that the value of local currency was fixed at a set exchange rate to gold ounces. This was
known as the gold standard. This allowed for unrestricted capital mobility as well as global stability
in currencies and trade. However, with the start of World War I, the gold standard was abandoned.
At the end of World War II, the conference at Bretton Woods, an effort to generate global
economic stability and increase global trade, established the basic rules and regulations governing
international exchange. As such, an international monetary system, embodied in the International
Monetary Fund (IMF), was established to promote foreign trade and to maintain the monetary
stability of countries and, therefore, that of the global economy.
It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar,
which in turn was pegged to gold at $35 per ounce. This meant that the value of a currency was
directly linked with the value of the U.S. dollar. So, if you needed to buy Japanese yen, the value
of the yen would be expressed in U.S. dollars, whose value, in turn, was determined in the value
of gold. If a country needed to readjust the value of its currency, it could approach the IMF to
adjust the pegged value of its currency. The peg was maintained until 1971 when the U.S. dollar
could no longer hold the value of the pegged rate of $35 per ounce of gold.
From then on, major governments adopted a floating system, and all attempts to move back to a
global peg were eventually abandoned in 1985. Since then, no major economies have gone back
to a peg, and the use of gold as a peg has been completely abandoned.
Key Differences
The reasons to peg a currency are linked to stability. Especially in today's developing nations, a
country may decide to peg its currency to create a stable atmosphere for foreign investment. With
a peg, the investor will always know what his or her investment's value is and will not have to
worry about daily fluctuations.
[Important: A pegged currency can help lower inflation rates and generate demand, which
results from greater confidence in the stability of the currency.]
Salman Azam Joiya
Economist
8
Fixed regimes, however, can often lead to severe financial crises, since a peg is difficult to maintain
in the long run. This was seen in the Mexican (1995), Asian (1997), and Russian (1997) financial
crises, where an attempt to maintain a high value of the local currency to the peg resulted in the
currencies eventually becoming overvalued. This meant that the governments could no longer meet
the demands to convert the local currency into the foreign currency at the pegged rate.
With speculation and panic, investors scrambled to get their money out and convert it into foreign
currency before the local currency was devalued against the peg; foreign reserve supplies
eventually became depleted. In Mexico's case, the government was forced to devalue the peso by
30 percent. In Thailand, the government eventually had to allow the currency to float, and, by the
end of 1997, the Thai bhat had lost 50 percent of its value as the market's demand, and supply
readjusted the value of the local currency.
Countries with pegs are often associated with having unsophisticated capital markets and weak
regulating institutions. The peg is there to help create stability in such an environment. It takes a
stronger system as well as a mature market to maintain a float. When a country is forced to devalue
its currency, it is also required to proceed with some form of economic reform, like implementing
greater transparency, in an effort to strengthen its financial institutions.
Some governments may choose to have a "floating," or "crawling" peg, whereby the government
reassesses the value of the peg periodically and then changes the peg rate accordingly. Usually,
this causes devaluation, but it is controlled to avoid market panic. This method is often used in the
transition from a peg to a floating regime, and it allows the government to "save face" by not being
forced to devalue in an uncontrollable crisis.
Although the peg has worked in creating global trade and monetary stability, it was used only at a
time when all the major economies were a part of it. While a floating regime is not without its
flaws, it has proven to be a more efficient means of determining the long-term value of a currency
and creating equilibrium in the international market.
Key Takeaways
• A floating exchange rate is determined by the private market through supply and demand.
• A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official
exchange rate.
• The reasons to peg a currency are linked to stability. Especially in today's developing nations, a
country may decide to peg its currency to create a stable atmosphere for foreign investment.
Managed Float
A managed-floating currency when the central bank may choose to intervene in the foreign
exchange markets to affect the value of a currency to meet specific macroeconomic objectives.
For example the central bank might attempt to bring about a depreciation to
Salman Azam Joiya
Economist
9
• (i) Improve the balance of trade in goods and services / improve the current account
position
• (ii) Reduce the risk of a deflationary recession - a lower currency increases export demand
and increases the domestic price level by making imports more expensive
• (iii) To rebalance the economy away from domestic consumption towards exports and
investment
• (iv) Selling foreign currencies to overseas investors as a way of reducing the size of
government debt
Or to bring about an appreciation of the currency
• (i) To curb demand-pull inflationary pressures
• (ii) To reduce the price of imported capital and technology
Overall, one key aim of managed floating currencies is to reduce the volatility of exchange rates.
This is because big fluctuations in the external value of a currency can increase investor risk and
perhaps damage business confidence. If the risk for example of overseas investor buying a
government’s bonds rises, then they may demand a higher interest rate (or yield) on those bonds
as compensation.
Managed floating exchange rates might also be used as a tool for a government to restore or
improve the price competitiveness of exporters in global markets or perhaps respond to an external
economic shock affecting their economy.
Latest IMF classification of countries using a managed floating system:
Albania, Argentina, Armenia, Brazil, Colombia, Georgia, Ghana, Guatemala, Hungary, Iceland,
India, Indonesia, Israel, Kazakhstan, Korea, Moldova, New Zealand, Paraguay, Peru, Philippines,
Romania, South Africa, Thailand, Turkey, Uganda, Ukraine, Uruguay
IMF classification of countries using a free-floating currency:
Australia, Canada, Chile, Japan, Mexico, Norway, Poland, Russia, Sweden, United Kingdom,
United States, European Union (Euro)
Salman Azam Joiya
Economist
