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Exchange Rates - Fixed & Managed

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by

Ciaran Fitzpatrick

on 4 November 2013

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Transcript of Exchange Rates - Fixed & Managed

Fixed Exchange Rates
Fixed by the Central Bank of the country - intervention
Not allowed to change due to market forces
Involves constant intervention
Buying & selling Reserve currency

Assume: 3 sol = $1
Represented by Point A
A decrease in the Demand for dollars caused by a decrease in the Demand for US exports.
Point C represents where equilibrium would be in a floating exchange market
Point C would eliminate the Balance of Payments Deficit
Problems with Fixed Exchange Rates
Additional Measures take place when there is Downward Pressure
Efforts to Limit Imports
Reduces Supply of Domestic currency
Reduces Demand for Foreign Exchange to buy imports

To restrict imports, governments can:
Contractionary Fiscal & Monetary Policy
Lowers AD - Lower incomes - Resulting in fewer imports

Protectionist Trade policies
Managed Float
Managed Float
Mixture between Fixed & Float
Acts more like Float
Free to float over long periods of time
Central Bank intervenes to stabilize over short periods for stability

Goal is to prevent abrupt fluctuations in the currency
If not, it can disrupt International flow of goods
At a fixed Exchange Rate of 3 sol = $1
Quantity of dollars Supplied is GREATER than Quantity of dollars Demanded
A deficit in the Balance of Payments exists (A - B)
Using Official Reserves to maintain the Fixed Exchange Rate - 3 sol = $1
If there is an excess of currency supplied/demanded the Central Bank must intervene
The excess Quantity Supplied of Dollars puts downward pressure on the dollar (Point A - Point C)
Sell excess Quantities of Sols
Purchase excess Dollars
Shifts Demand to the right
Maintains exchange rate at 3 sol = $1
If there was an excess Quantity Demanded
Central Bank would sell dollars
Buy sols
Problems:
Extended periods of downward pressure
Central Bank runs out of Sols
At that point, they are unable to continue buying dollars

This occurs when governments are faced with deficits over long periods
If there is upward pressure (excess Quantity demanded), the Central Bank would continue to sell Sols
Increase Interest Rates
Attracts Foreign Investment
Increases Demand for currency
Changing the Fixed Interest Rate
Devaluation
Currency has higher value than can be maintained.
Government can change the fixed rate to a new lower rate
Revaluation:
Lower value than can be maintained, government sets new higher value
Consequences of Devaluation/Revaluation
Devaluation:
cheaper exports for foreigners
Imports are more expensive

Revaluation:
Exports become more expensive
Cheaper imports
Intervention
Buying & Selling of currencies
Changing of Interest Rates
Increase interest rates
Attract Investment - Increase Demand for currency
Decrease Interest Rates
Foreign Investment less attractive
Decrease in Demand for Currency
Pegging Exchange Rates
Countries Peg their currency to another currency
Allowed to float within a range
Trades outside - intervention takes place
Assume: The Sol is Pegged to the Dollar with a range of 3.50 - 2.50

If the Exchange Rate drops to 2.50 because of a decrease in USA exports
Central Bank will intervene by selling sols
Buying dollars
Demand will shift back to the right
Action will keep the Sol within the Pegged range
If the Dollar appreciates & approaches $1 = 3.50
Central Bank will intervene to stop the Sol depreciation
Sell Dollars
Buy Sols
Prevent further depreciation of the sol
Overvalued Currency:
Value is set high relative to the equilibrium free market value
Currency has been set high

Undervalued Currency:
Value is low relative to Free Market value
Value has been set lower
Problems with Overvalued & Undervalued Currencies
Overvalued Currencies:
Developing countries often Peg their currency against a stronger economy for a variety of reasons.

Pros:
Foreign Exchange can be bought cheaply
Imports are cheaper
Raw materials are cheaper
Helps speed up industrialization
Cons:
Exports of Domestic goods become expensive
Balance of Payment Problems
Worsening Trade Balance (payment difficulties)
Domestic employment is hurt
Undervalued Currency
Exports become cheap to foreigners
Imports become more expensive
Sometimes used by developing countries to help expand exports
Helps increase Domestic Employment
Considered "cheating" - "Dirty Float"
Revaluation needed to correct
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