MADE BY: MEGHA SINGH (9502926) ASHISH MANRAL (9502927) SAURABH SHARMA (9502928) ARVIND KR.

CHAUHAN (9502930) NIMISH SAXENA (9502932)

the exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market.

What are the most common types of exchange rate regimes?

Fixed Exchange Rate Floating Exchange Rate Pegged Exchange Rate

Definition: in a fixed exchange rate system the government or central bank intervenes in the currency market so that the exchange rate stays close to an exchange rate target.

The central bank is unable to affect the exchange rate through monetary policy. However, the central bank can use fiscal expansion to create an excess demand for the currency causing a rise in domestic output. The central bank will then purchase foreign assets to increase the money supply, and prevent the interest rate from rising causing an appreciation.
Due to these limitations the government of a country with a fixed exchange rate will want to control the amount of currency they let in and out. This will prevent any unwanted destabilization of the domestic currency.

 Definition:

a countrys currency is set by the foreign-exchange market through supply and demand for that particular currency relative to other currencies. In a floating exchange rate system the value of the currency is affected by everyday markets for supply and demand. Therefore trade and capital flows play a big role in determining the currencys value.

The exchange rate can be stabilized through both monetary and fiscal policy: Through monetary policy when there is an excess in money supply the government would purchase domestic assets to weaken the currency and push the interest rate down. Fiscal expansion causes an appreciation of the currency that forces the government to purchase foreign assets. This will increase the money supply preventing the currency appreciation.

Clean Float
Supply and demand are solely private activities. Complete flexibility

Dirty Float (Managed Float)

From

time to time, the government tries to impact the rate through intervention. More popular than clean float

FIXED EXCHANGE RATES What happens if the official rate differs from the rate determined by supply and demand?

 When

the official rate is above its fundamental value, the currency is said to be overvalued country could devalue the currency, reducing the official rate to the fundamental value

The

The government can supply or demand the currency to make the fundamental value equal to the official rate

If the currency is overvalued, the government can buy its own currency This is done by the nations central bank using its official reserve assets to buy the domestic currency in the foreign exchange market Official reserve assets include gold, foreign bank deposits, and special assets created by agencies like the International Monetary Fund The decline in official reserve assets is equal to a countrys balance of payments deficit

country cant maintain an overvalued currency forever, as it will run out of official reserve assets

In the gold standard period, countries sometimes ran out of gold and had to devalue their currencies A speculative run (or speculative attack) may end the attempt to support an overvalued currency

If investors think a currency may soon be devalued, they may sell assets denominated in the overvalued currency, increasing the supply of that currency on the foreign exchange market

Similarly, in the case of an undervalued currency, the official rate is below the fundamental value

In this case, a central bank trying to maintain the official rate will acquire official reserve assets If the domestic central bank is gaining official reserve assets, foreign central banks must be losing them, so again the undervalued currency cant be maintained for long

To improve a poor macroeconomic situation, a country increases its money supply so that banks are more willing to lend.

Interest rate drops

Capital flows out. (in the short run)

The overall payments balance worsens.

The Current account balance worsens as exports fall and imports increase.

Real spending, production, and income rise, but The price level increases.

A higher money supply (than the level of the money supply for which the fundamental value of the exchange rate equals the official rate) yields an overvalued currency A lower money supply yields an undervalued currency This implies that countries cant both maintain the exchange rate and use monetary policy to affect output

Capital flows out.

With an increase in the money supply, banks are more willing to lend.

Interest rate drops

(In the short run) Currency depreciation and automatic adjustment begins!
Current account balance worsens.

The Current account balance improve s

Real product and income rise more

Real spending, production, and income rise.

The Price level increases. (Beyond the short run)

 Flexible-exchange-rate

systems also have problems, because the volatility of exchange rates introduces uncertainty into international transactions There are two major benefits of fixed exchange rates
Stable exchange rates make international trades easier and less costly Fixed exchange rates help discipline monetary policy, making it impossible for a country to engage in expansionary policy; the result may be lower inflation in the long run

 But

there are some disadvantages to fixed exchange rates

They take away a countrys ability to use expansionary monetary policy to combat recessions Disagreement among countries about the conduct of monetary policy may lead to the breakdown of the system

If large benefits can be gained from increased trade and integration, and when countries can coordinate their monetary policies closely, then fixed exchange rates may be desirable Countries that value having independent monetary policies, either because they face different macroeconomic shocks or hold different views about the costs of unemployment and inflation than other countries, should have a floating exchange rate

 Fixed

exchange rates are government controlled. Floating exchange rates are market driven. fixed rates reduce the uncertainty of unstable currency values but movements in exchange rates provide a useful shock absorber for real disturbances to the world economy, but they are also a significant source of uncertainty for trade and capital formation