Exchange rate policy

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Intros
Lessons
  1. 3 types of Exchange Rate Policies
    • Flexible Exchange Rate
    • Fixed Exchange Rate
    • Crawling Peg
  2. Flexible Exchange Rate
    • Exchange rate from demand and supply
    • No direct intervention by central bank
    • Central Bank can indirectly intervene
    • Central Bank can indirectly intervene
  3. Crawling Peg
    • Similar to fixed exchange rate
    • Gradual appreciation or depreciation
    • Minimize economic dislocation
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Examples
Topic Notes
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3 Types of Exchange Rate Policies

Since the exchange rate contributes massively to the economy, both governments and central banks must have a policy for the exchange rate.

The three policies that we will be looking at are:
  1. Flexible exchange rate
  2. Fixed exchange rate
  3. Crawling peg


Flexible Exchange Rate

Flexible Exchange Rate: the exchange rate determined by the demand and supply in the foreign exchange market and has no direct intervention by the government or central bank.

However, the central bank can indirectly intervene by doing one of the two examples:
  1. Increase interest rate   \,   \, Demand for US dollars  ↑  \, \uparrow \,   \, Supply for US dollars  ↓  \, \downarrow \,   \, exchange rate  ↑ \, \uparrow .
  2. Decrease interest rate   \,   \, Demand for US dollars  ↓  \, \downarrow \,   \, Supply for US dollars  ↑  \, \uparrow \,   \, exchange rate  ↓ \, \downarrow .

Though the central bank can change the interest rate to change exchange rate, that is not their purpose in a flexible exchange rate regime. When they change their interest rate, it is mainly due to changing a monetary policy objective.


Fixed Exchange Rate

Fixed Exchange Rate: an exchange rate determined by the government or central bank and can be attained by blocking the forces of demand and supply in the foreign exchange market.

The fixed exchange rate is what the central bank wants.

Note: In order to attain a fixed exchange rate, there must be intervention by the government or central bank.

To keep a fixed exchange rate, the central bank/government must do the following:
  1. If exchange rate rises above the target value, then they sell US dollars.
  2. If exchange rate falls below the target value, then they buy US dollars.


Note: The Fed has no limit to how much US dollars they can sell, but they have a limit to how much US dollars they can buy.

This is because the Fed can create any quantity of US dollars it chooses but buying US dollars requires the Fed to sell foreign currencies which they have a limited amount of.

Suppose the targeted fixed exchange rate is 4 Yuan’s per US dollar for the central bank.

Exchange Rate Policy


There are four cases of the central bank keeping its fixed exchange rate.

Case 1: The demand for US dollars increases temporarily, so the demand for US dollars shifts from D0D_{0} to D1D_{1} . In this case, the Fed would sell 0.4 trillion US dollars to stop the exchange rate from increasing.

Exchange Rate Policy


This keeps the fixed exchange rate as 4.

Case 2: The demand for US dollars decreases temporarily, so the demand for US dollars shifts from D0D_{0} to D1D_{1} . In this case, the Fed would buy 0.4 trillion US dollars to stop the exchange rate from decreasing.

Exchange Rate Policy


This keeps the fixed exchange rate as 4.

Case 3: The demand for US dollars increases permanently, so the demand for US dollars shifts from D0D_{0} to D1D_{1} . In this case, the Fed would have to sell 0.4 trillion US dollars every day to stop the exchange rate from increasing.

Exchange Rate Policy


Selling US dollars every day means they must buy foreign currency every day. At some point, they must stop piling up foreign currency reserves, which means abandoning the fixed exchange rate.

Case 4: The demand for US dollars decreases permanently, so the demand for US dollars shifts from D0D_{0} to D1D_{1} . In this case, the Fed would have to buy 0.4 trillion US dollars every day to stop the exchange rate from decreasing.

Exchange Rate Policy


Buying US dollars every day means they must sell foreign currency every day. At some point, the Fed will run out of foreign currencies to sell, so they would have to abandon the fixed exchange rate.


Crawling Peg

Crawling Peg: an exchange rate regime like that of the fixed exchange rate, except it allows gradual depreciation or appreciation of an exchange rate.

The targeted exchange rate can change daily, weekly, monthly, or even at random time intervals.

The system is designed to β€œglide” in response to market uncertainties or inflation, and to minimize major economic dislocation.