Types of Exchange Rate Systems (HL IB Economics)

Foreign Exchange Rates

• An exchange rate is the price of one currency in terms of another e.g. £1 = €1.18

  • International currencies are essentially products that can be bought & sold on the foreign exchange market (forex)
     

• The Central Bank of a country controls the exchange rate system that is used in determining the value of a nation's currency
    

• Three of the main exchange rate systems are

  • A floating exchange rate

  • A fixed exchange rate

  • A managed exchange rate

1. A Floating Exchange Rate System

• Different currencies can be bought and sold, just like any other product

• The forces of demand and supply determine the rate at which one currency exchanges for another

• As with any market, if there is excess demand for the currency on the forex market, then prices rise (the currency appreciates)

• If there is an excess supply of the currency on the forex market, then prices fall (the currency depreciates) 
  

The relationship between the US$ and the Euro shows that as Europeans demand the $ it appreciates but by supplying their own currency it depreciates

 
Diagram Analysis

• The Euro/US$ market is shown by two market diagrams - one for the USD market on the left and one for the Euro market on the right

• The initial exchange rate equilibrium is found at P₁Q₁ in both markets

• When Europeans visit the USA, they demand US$ and supply Euros

  • The increased demand for the US$ shifts the demand curve to the right which results in the value of the $ appreciating from P₁ → P₂ in the USD market and a new market equilibrium forms at P₂Q₂

  • The increased supply of the Euro shifts the supply curve to the right which results in the value of the Euro depreciating from P₁ → P₂  and a new market equilibrium forms at P₂Q₂

Floating Exchange Rate Calculations

• As the value of a currency appreciates or depreciates, the value of any international transaction changes

• These changes can be significant for firms during times of exchange rate volatility
  

2. A Fixed Exchange Rate System

• A system in which the country’s Central Bank intervenes in the currency market to fix (peg) the exchange rate in relation to another currency e.g US$

  • When they want their currency to appreciate, they buy it on forex markets using their foreign reserves, thus increasing its demand

  • When they want their currency to depreciate, they sell it on forex markets, thus increasing its supply

• Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1 Singapore Dollar

• Often the peg is not at parity e.g. Hong Kong has pegged its currency to the US$ at a rate of HK$ 7.75 = US$ 1

• A revaluation occurs if the Central Bank decides to change the peg and increase the strength of its currency

• A devaluation occurs if the Central Bank decides to change the peg and decrease the strength of its currency
    

The Hong Kong Monetary Authority intervenes to maintain the exchange rate of HK$ 7.75 = US$ 1
 

Diagram Analysis

• The HK$/US$ market is shown by two market diagrams - one for the HK$ market on the left and one for the US$ market on the right

• The initial exchange rate equilibrium is found at HK$ 7.75 = US$ 1  - represented by point 1

• When Hong Kong firms import goods from the USA, they demand US$ to pay for them and supply HK$

• This impacts the market for each currency - the US$ appreciates and the HK$ depreciates

• To maintain the fixed exchange rate at HK$ 7.75 = US$ 1, the Hong Kong Monetary Authority intervenes in the forex market by using US$ from its foreign reserves to buy HK$
   

 Left Diagram - HK$

• The increased supply of the HK$ shifts the supply curve to the right which results in the value of the HK$ depreciating from (HK$7.75 = $1) → (HK$7.75 = $0.97)  and a new market equilibrium forms at point 2

• The Monetary Authority intervenes by buying HK$ which shifts the demand curve right from D₁ → D₂

• The HK$ has now been moved back to its target value of K$ 7.75 = US$ 1 - point 3

Right Diagram - US$

• The increased demand for the US$ shifts the demand curve to the right which results in the value of the US$ appreciating from  ($1 = HK$7.75) → ($1 = HK$7.98)  and a new market equilibrium forms at point 2

• The Monetary Authority intervenes by buying HK$ using UD$ which increases their supply shifting the supply curve right from S₁ → S₂

• The HK$ has now been moved back to its target value of K$ 7.75 = US$ 1 - point 3

3. A Managed Exchange Rate System

• The exchange rate is allowed to fluctuate within a specified band around a desired valuation. If it goes outside of this band then the Central Bank will intervene to bring it back within the band
  

  • When they want their currency to appreciate to back within the band, they buy it on forex markets using their foreign reserves, thus increasing its demand

  • When they want their currency to depreciate back into the band, they sell it on forex markets, thus increasing its supply
     

• Currently, almost all currencies are managed currencies

  • The width of the band varies from country to country

  • These bands are not published as it would help  currency speculators to know when currency reversals would be initiated by the Central bank and they would seek to profit from that knowledge 

The Peoples Bank of China intervenes to maintain the exchange rate within a specified band of trading and is in the region of 2% around a value of 1US$ = 6.75 CNY
  

Diagram Analysis

• China has not released their currency bands, however, the value seems to fluctuate up to 2% around a value of 1US$ = 6.75 CNY

•  The initial market equilibrium is found at ER₁ Q₁
   

Action to correct currency appreciation

• Increased demand for the Chinese Yuan leads to a rightward shift of demand D₁→D₂ leading to an appreciation from ER₁→ER₂

• The currency is approaching the upper band so the Peoples Bank of China intervenes by selling their own currency (and buying foreign reserves)

  • This increases the supply of the Yuan causing a rightward shift from S₁→S₂

  • A new equilibrium is established at ER₁Q₃, well within the band

Action to correct currency depreciation

• Increased supply of the Chinese Yuan on world markets leads to a rightward shift of supply from S₁→S₂ leading to a depreciation from ER₁ towards the bottom currency band

• The currency is approaching the bottom band so the Peoples Bank of China intervenes by buying their own currency (and selling foreign reserves)

  • This increases the demand of the Yuan causing a rightward shift from D₁→D₂

  • A new equilibrium is established at ER₁Q₃, well within the band