THE DETERMINATION OF EXCHANGE RATES: Major Types of Exchange Systems
Major Types of Exchange Systems
As noted earlier, exchange rates are either freely floating or fixed to something. The following sections explain how rates change under three major types of exchange-rate systems: freely fluctuating, managed fixed, and automatic fixed. In addition, the roles of purchasing-power parity, the Fisher Effect, and other factors related to the relationships between currencies are discussed.
Freely Fluctuating
To understand the law of supply and demand as it relates to foreign exchange, we will use a two-country model involving the United States and Japan. Figure 8.1 illustrates the concept of equilibrium in the market and then a movement to a new equilibrium level as situations change. The demand for yen in this example is a function of U.S. demand for: (1) Japanese goods and services and (2) yen-denominated financial assets. An example of the former would be the U.S. demand for yen to buy Japanese-made autos. An example of the latter would be U.S. demand for yen to buy Japanese securities. The supply of yen (which is tied to the demand for dollars in this illustration) is a function of Japanese demand for: (1) U.S. goods and services and (2) dollar-denominated financial assets. Initially, the supply of and demand for yen in Fig. 8.1 is at the equilibrium exchange rate e0 (for example, $0.00667 per yen, or 150 yen per dollar) and the quantity of yen
Assume that there is a drop in demand for U.S. goods and services by Japanese consumers because of, say, relatively high U.S. inflation. This would result in a reduction in the supply of yen in the foreign-exchange market, causing the supply curve to shift to S'. Simultaneously the increasing prices of U.S. goods might lead to an increase in demand for Japanese goods and services by U.S. consumers, which would lead to an increase in demand for yen in the market, causing the demand curve to shift to D', and finally leading to an increase in the quantity demanded and an increase in the exchange rate. Thus the new equilibrium exchange rate will be at ex (for example,
$0.00769 per yen, or 130 yen per dollar). From a dollar standpoint we could say that the increase in demand for Japanese goods would lead to an increase in supply of dollars as more consumers tried to trade their dollars for yen, and a reduction in demand for U.S. goods would result in a drop in demand for dollars. This would result in a reduction in the price of the dollar, indicating a weakening or depreciation or devaluation of the dollar.
Managed Fixed Exchange Rate
In the preceding example, Japanese and U.S. authorities allowed changes in the exchange rates between their two currencies to occur in order to reach a new currency equilibrium. In fact, however, one or both of the countries might not want exchange rates to change. For example, assume that the United States and Japan decide to manage their exchange rates. The U.S. government might not want its currency to weaken, because its businesses would have to pay more for Japanese products, which would lead to more inflationary pressure in the United States. The Japanese government might not want the yen to strengthen because it would mean unemployment in its export industries. But how can the governments keep the values from changing when the United States is earning too few yen? Somehow the shortage between yen wanted and yen available must be alleviated.
In a managed system, the Federal Reserve of New York holds foreign-exchange reserves, which it has built up through the years for this type of contingency. It could sell enough of its yen reserves (make up the difference between Q, and Q3) at the fixed exchange rate to maintain the exchange rate. Or the Japanese central bank might be willing to accept dollars so that U.S. consumers can continue to buy Japanese goods. These dollars would then become part of the Japanese foreign-exchange reserves.
The fixed rate can continue as long as the United States has reserves and/ or as long as the Japanese are willing to add dollars to their holdings. Unless something changes the basic imbalance in the currency supply and demand, though, the Federal Reserve Bank of New York will run out of yen and the Japanese central bank will stop accepting dollars because it fears that it holds too many. At this point it would be necessary to change the exchange rate so as to lessen the demand for yen.
Once a government decides that intervention will not work, it must adjust the value of its currency. If the currency is freely floating, the exchange rate will seek the correct level according to the laws of supply and demand. However, a currency that is pegged or fixed to another currency or to a group of currencies usually is changed on a formal basis with respect to its reference currency or currencies. This formal change is termed more accurately a devaluation or revaluation, depending on which direction the change takes. If the foreign-currency equivalent of the home currency falls (or the home-currency equivalent of the foreign currency rises), then the home currency has devalued in relation to the foreign currency. The opposite would happen in tne case of a revaluation.
Automatic Fixed Rate System
As in the managed system just discussed,
let us assume that the countries have agreed to maintain fixed rates by setting their domestic money supply on the basis of the amount of reserves held by the central bank and by denominating their currency value in terms of the reserve asset. Historically, the major reserve asset has been gold. In the latter part of the nineteenth century, most countries were on a gold standard.
Consider the Japanese situation in which the United States has a shortage of yen. Under an automatic fixed rate system the United States hypo-thetically would now sell gold to get the needed yen. However, unlike the managed system just described, there would be automatic adjustments to prevent the United States from running out of gold. As the United States sold off some of its gold, its money supply, which is tied to the amount of gold, would then fall. This would lead to higher U.S. interest rates as well as lower U.S. investment, followed by increased unemployment and lower prices. Meanwhile, the increase in gold in Japan would be having an opposite effect. The higher interest rates in the United States than in Japan and the decrease in U.S. prices relative to Japanese prices would cause an increase in the supply of yen in the United States as funds flowed in for investments and to purchase U.S. goods and services. This would result in a strengthening of the dollar and a weakening of the yen.
Thus, although the law of supply and demand can determine exchange rates in an open market, many governments intervene in the market to impact exchange rate movements. Although the automatic fixed rate system is possible, it is not as widely seen as the freely fluctuating and managed exchange rate systems.
As noted earlier, exchange rates are either freely floating or fixed to something. The following sections explain how rates change under three major types of exchange-rate systems: freely fluctuating, managed fixed, and automatic fixed. In addition, the roles of purchasing-power parity, the Fisher Effect, and other factors related to the relationships between currencies are discussed.
Freely Fluctuating
To understand the law of supply and demand as it relates to foreign exchange, we will use a two-country model involving the United States and Japan. Figure 8.1 illustrates the concept of equilibrium in the market and then a movement to a new equilibrium level as situations change. The demand for yen in this example is a function of U.S. demand for: (1) Japanese goods and services and (2) yen-denominated financial assets. An example of the former would be the U.S. demand for yen to buy Japanese-made autos. An example of the latter would be U.S. demand for yen to buy Japanese securities. The supply of yen (which is tied to the demand for dollars in this illustration) is a function of Japanese demand for: (1) U.S. goods and services and (2) dollar-denominated financial assets. Initially, the supply of and demand for yen in Fig. 8.1 is at the equilibrium exchange rate e0 (for example, $0.00667 per yen, or 150 yen per dollar) and the quantity of yen
Assume that there is a drop in demand for U.S. goods and services by Japanese consumers because of, say, relatively high U.S. inflation. This would result in a reduction in the supply of yen in the foreign-exchange market, causing the supply curve to shift to S'. Simultaneously the increasing prices of U.S. goods might lead to an increase in demand for Japanese goods and services by U.S. consumers, which would lead to an increase in demand for yen in the market, causing the demand curve to shift to D', and finally leading to an increase in the quantity demanded and an increase in the exchange rate. Thus the new equilibrium exchange rate will be at ex (for example,
$0.00769 per yen, or 130 yen per dollar). From a dollar standpoint we could say that the increase in demand for Japanese goods would lead to an increase in supply of dollars as more consumers tried to trade their dollars for yen, and a reduction in demand for U.S. goods would result in a drop in demand for dollars. This would result in a reduction in the price of the dollar, indicating a weakening or depreciation or devaluation of the dollar.
Managed Fixed Exchange Rate
In the preceding example, Japanese and U.S. authorities allowed changes in the exchange rates between their two currencies to occur in order to reach a new currency equilibrium. In fact, however, one or both of the countries might not want exchange rates to change. For example, assume that the United States and Japan decide to manage their exchange rates. The U.S. government might not want its currency to weaken, because its businesses would have to pay more for Japanese products, which would lead to more inflationary pressure in the United States. The Japanese government might not want the yen to strengthen because it would mean unemployment in its export industries. But how can the governments keep the values from changing when the United States is earning too few yen? Somehow the shortage between yen wanted and yen available must be alleviated.
In a managed system, the Federal Reserve of New York holds foreign-exchange reserves, which it has built up through the years for this type of contingency. It could sell enough of its yen reserves (make up the difference between Q, and Q3) at the fixed exchange rate to maintain the exchange rate. Or the Japanese central bank might be willing to accept dollars so that U.S. consumers can continue to buy Japanese goods. These dollars would then become part of the Japanese foreign-exchange reserves.
The fixed rate can continue as long as the United States has reserves and/ or as long as the Japanese are willing to add dollars to their holdings. Unless something changes the basic imbalance in the currency supply and demand, though, the Federal Reserve Bank of New York will run out of yen and the Japanese central bank will stop accepting dollars because it fears that it holds too many. At this point it would be necessary to change the exchange rate so as to lessen the demand for yen.
Once a government decides that intervention will not work, it must adjust the value of its currency. If the currency is freely floating, the exchange rate will seek the correct level according to the laws of supply and demand. However, a currency that is pegged or fixed to another currency or to a group of currencies usually is changed on a formal basis with respect to its reference currency or currencies. This formal change is termed more accurately a devaluation or revaluation, depending on which direction the change takes. If the foreign-currency equivalent of the home currency falls (or the home-currency equivalent of the foreign currency rises), then the home currency has devalued in relation to the foreign currency. The opposite would happen in tne case of a revaluation.
Automatic Fixed Rate System
As in the managed system just discussed,
let us assume that the countries have agreed to maintain fixed rates by setting their domestic money supply on the basis of the amount of reserves held by the central bank and by denominating their currency value in terms of the reserve asset. Historically, the major reserve asset has been gold. In the latter part of the nineteenth century, most countries were on a gold standard.
Consider the Japanese situation in which the United States has a shortage of yen. Under an automatic fixed rate system the United States hypo-thetically would now sell gold to get the needed yen. However, unlike the managed system just described, there would be automatic adjustments to prevent the United States from running out of gold. As the United States sold off some of its gold, its money supply, which is tied to the amount of gold, would then fall. This would lead to higher U.S. interest rates as well as lower U.S. investment, followed by increased unemployment and lower prices. Meanwhile, the increase in gold in Japan would be having an opposite effect. The higher interest rates in the United States than in Japan and the decrease in U.S. prices relative to Japanese prices would cause an increase in the supply of yen in the United States as funds flowed in for investments and to purchase U.S. goods and services. This would result in a strengthening of the dollar and a weakening of the yen.
Thus, although the law of supply and demand can determine exchange rates in an open market, many governments intervene in the market to impact exchange rate movements. Although the automatic fixed rate system is possible, it is not as widely seen as the freely fluctuating and managed exchange rate systems.
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