Exchange Rate Systems

Exchange Rate Systems

 Every country must choose an exchange rate system- the

rate at which home country currency converts into foreign
currency

 An exchange rate system determines how prices in home

country currency are converted into prices in foreign
currency

 There is a continuum from completely fixed to completely

flexible system
Types of Exchange Rate Systems

 Fixed Exchange Rate System: The exchange rate, in nominal terms,

is fixed by the monetary authority of the country, regardless of the
demand and supply of foreign currency
 Hard pegs
 Soft pegs

 Flexible Exchange Rate System: Market forces of demand and supply

determine the exchange rate which changes with demand and supply

 Managed Float: Where exchange rates are allowed to freely float with
intervention by the monetary authority to prevent excess volatility
Prerequisites for any Exchange Rate
System
 The governments and central banks should have credible
policies to support the selected system

 This is important as movements in trade, capital flows and

other pressures push exchange rates up or down

 Foreign exchange reserves are, for example, needed to

maintain a fixed or managed float exchange rate system
Exchange Rate in the Long run

 According to the Purchasing Power Parity theory, in the

long run the exchange rates would settle at the level
where the two currencies will be able to buy identical
basket of goods in both the countries

Price Cost of same basket of goods

Price in dollars $1000
Price in pounds £ 500
Long-run equilibrium exchange rate $2/£
Long run equilibrium exchange rate

 If the exchange rate rises above $2/£ to $3/£, the pound

is said to be overvalued

 An overvalued pound will buy more in the United States

than it would in UK

 If the exchange rate falls below $2/£ to $1.75/£, the

pound is said to be undervalued and it would buy lesser in
USA than it would in UK
Restoration of Equilibrium exchange rate

 Goods will move across international borders thus making

goods expensive in a country with overvalued currency
and vice versa

 Or foreign exchange dealers will sell the overvalued

currency and drive down its value and vice versa

 Equilibrium will be restored by price changes or exchange

rate changes or both
Exchange rates in the Medium Run and
Short Run
 Medium Run
 Economic growth of the country- higher economic growth,
ceteris paribus, tends to depreciate the home currency
 Economic growth in the rest of the world- higher world
economic growth can lead to more exports and appreciation
of home currency
 Short run
 Flow of financial capital- debt and equity
 Can increase or decrease because of (i) interest rates and
(ii) expectations about future exchange rates
Nominal and Real Exchange Rate

 Nominal exchange rates merely tell us how much one currency

is worth in terms of another currency

 To know the purchasing power of the currencies, however, we

need to know the price levels of the two countries

 If USD and Malaysian Ringgit exchange rate stays constant at

$0.25 to a ringgit but inflation in Malaysia over the year is 4%
and 1% in the US then the ringgit’s purchasing power would be
eroded
Real Exchange Rate

 The real exchange rate is the market exchange rate adjusted for price
differences

 What matters to exporters and importers is the real exchange rate-

how much purchasing powers they have in the countries under
comparison

 An American importer trying to decide between importing Malaysian

or Chinese textiles doesn’t care if she gets 4 ringgits per dollar or 8
yuan per dollar

 What matters is the volume of textiles that 4 ringgits will buy in

Malaysia or 8 yuan will buy in China
Determination of Real Exchange Rate

 Real Exchange Rate = Nominal Exchange Rate x Foreign

prices/Domestic Prices

 Rr = Rn(P*/P)
 Where Rr = Real exchange rate
Rn= Nominal exchange rate
P* = Foreign Price
P = Domestic price