A government may try to stabilise the exchange rate for its currency. The purpose of having an exchange rate policy would be to create stable economic conditions for international trade. A stable exchange rate, with relatively little exchange rate volatility, should help to promote growth in the country’s economy.
In the past, some governments were able to manage the exchange rate by dealing on the foreign exchange markets, using their official reserves of foreign exchange to either buy or sell domestic currency. By creating demand or supply for its currency in the markets, the government would try to move the exchange rate up or down against major currencies such as the dollar. However, the foreign exchange markets are now so large that very few countries are in a position to manage the exchange rate effectively in this way. (Countries such as China may be an exception.)
The most effective way for a government to manage its exchange rate today, if it wished to do so, would be to increase or reduce domestic interest rates on its currency. Raising or reducing interest rates should affect the demand for the currency from investors. For example, raising the interest rate should attract more investment into the currency, and by increasing demand for the currency, the foreign exchange value of the currency should increase.
There are several exchange rate policies that a government might adopt. These include:
free floating (‘benign neglect’ of the exchange rate)
managed floating of the currency
a fixed exchange rate policy, with the exchange rate fixed against a major currency or a basket of world currencies
a fixed exchange rate backed by a currency board system.
Free floating
With a policy of free floating, the government does not have a policy about the exchange rate. Instead, it allows the currency to find its own market value in the foreign exchange markets.
Managed floating
A policy of managed floating is to allow the currency to find its own level in the foreign exchange markets, but within target limits. (Targets may be set for the maximum and minimum exchange rate against, say, the US dollar or the euro.) If the exchange rate threatens to go through the upper or lower target limit, the government will act to try to keep it within the policy limits, probably by raising or lowering interest rates.
Fixed exchange rate policy
A government might try to fix its exchange rate against:
another currency, such as the US dollar, or
a basket of other world currencies, for example the US dollar, euro and yen.
The ‘fixed rate’ policy will normally permit some limited variations in the exchange rate.
For example, countries that wish to enter the eurozone in the European Community are expected to link their currency to the value of the euro for a period of time before they can be considered for ‘eurozone membership’.
There are problems with fixing an exchange rate against another currency.
Economic conditions in the two countries must remain similar; otherwise there will be too much pressure on the exchange rate to change. For example, the rate of inflation in both countries must be similar over a long period of time.
The country’s economy will be affected by any crisis in the economy of the other country, or by an increase in the volatility of the other country’s currency.
Fixed exchange rate backed by a currency board
A currency board system is another fixed exchange rate system. The government fixes its currency against the value of another currency (a ‘hard’ currency, such as the US dollar). Any new issues of domestic currency have to be backed by an amount of the ‘hard currency’ in the country’s official reserves.
For example, a country with a currency board system might fix the exchange rate at 4 local currency units (LCUs) to the US dollar. If the country wants to increase its money supply (which will be necessary for economic growth), it will need to hold reserves of one US dollar for every increase of 4 LCUs in the money supply.
This ‘backing’ of a hard currency should help to stabilise the exchange rate for the country’s own currency, which in turn should help the country to achieve economic stability.
A problem with a currency board system is that on occasions:
it might result in a shortage of domestic money supply, because of an insufficiency of the hard currency, or
it might push up domestic interest rates (in order to attract more hard currency).
If the problem becomes too serious, the currency board system may break down. A currency board system has worked well for Hong Kong (whose dollar has been linked to the US dollar), but has not been so successful in other cases (such as Argentina).
The FX markets: spot rates
Bid and offer rates
Spot rates
Quoting exchange rates
2 The FX markets: spot rates
You need to understand how currencies are bought and sold in the FX markets. This section of the chapter explains the basic ‘rules’ for buying and selling currency.