Exchange Rate System

Exchange Rate System

Floating exchange rate system
The exchange rate is freely determined by demand and supply in a floating exchange rate system. Here, there is no intervention by the government in the foreign exchange market. There is no need for the government to accumulate reserve of foreign currencies for the purpose of purchasing domestic currency when demand is low or supply rises. Government can use those funds for other purposes. But businesses do not like the uncertainty associated with the floating exchange rate system. Exchange rate fluctuations make planning difficult and result in exchange loss if movement is unfavourable to them, especially those that engage in international transactions such as selling to other countries or importing raw materials from other countries.

The exchange rate is the price of the currency attained where demand for the currency and supply of the currency are equal (see Figure 1 below). The exchange rate is allowed to rise (appreciate) or fall (depreciate). There are several factors that can cause a change in the exchange rate. These factors either affect the demand or supply of the currency. The demand for a currency implies that the currency is being bought and supply of a currency means it is being sold in order to have another currency. A change in any of the factors will lead to either appreciation or depreciation of the currency. Some of the factors include:

 

Demand for exports and imports
The demand for a country’s products in other countries will increase the demand for that country’s currency since  payments have to be made in the exporter’s currency.  The demand curve shifts rightwards leading to a rise in currency value or appreciation of the domestic currency. In Figure 1 below, the demand for Nigerian exports by Japanese consumers increased the demand for the Nigerian naira (₦)  from D1 to D2. Japanese customers will go to their financial institutions and buy naira with their own currency (yen). Consequently, the value of the Nigerian naira appreciates against the Japanese yen (¥).

 

Figure 1: Appreciation of the naira due to increase in the exports of Nigeria
Graph showing appreciation of the naira due to increase in the exports of Nigeria

When a country wants to import goods from another country, it has to exchange (sell) its own currency and obtain the foreign currency from the bank. The imports are paid for in the currency of the country where the goods are coming from. Selling the domestic currency increases supply, leading to depreciation of the currency. Ghana cedi depreciated because its supply increased when it was sold to obtain the euro for paying for imports from France (Figure 2 below). 


Figure 2: Depreciation of the cedi due to increase in imports by Ghana

Graph showing depreciation of the cedi due to increase in imports by Ghana


Relative interest rate

If the interest rate in the domestic economy is higher than the one in a foreign country, foreigners will want to take advantage by depositing money in financial institutions in the domestic economy. They will have to buy or demand for the country’s currency in order to open savings accounts. The increase in demand will raise the exchange rate (see Figure 1 above).

There will be an outflow of money from a country if its interest rate is lower than what is obtainable abroad. This makes people sell the local currency to exchange for a foreign currency, thereby increasing the supply of the local currency and causing depreciation (see Figure 2 above).


Relative inflation rate

A relatively higher inflation rate in a particular country can decrease  the demand for its goods or exports because they are not price competitive. Therefore,  demand for its currency declines and the currency  falls in value. Also, there will be less inward flow of investment funds into a country with higher inflation rate, thereby decreasing demand for its currency and depreciating it (see Figure 3 below).

 

Figure 3: Depreciation due to decrease in the demand for a currency

A graph showing depreciation due to decrease in the demand for a currency


Rising 
income

Economic growth leads to rising incomes in a country as employment opportunities increase. There will be more demand for imports because consumers have more purchasing power. The domestic currency will be exchanged for foreign currencies in order to pay for imports. This causes an increase in the supply of domestic currency and a drop in its value (see Figure 2 above).

A rise in income in trading partners will increase demand for a country’s products and currency leading to appreciation (see Figure 1 above).

 

Relative investment opportunities
Improved investment prospects will reduce the rate at which investors leave the economy and sell the domestic currency. The supply of domestic currency reduces leading to currency appreciation (see Figure 4 below). 

The demand for the domestic currency will fall if there are less attractive investment opportunities in the country making the currency to depreciate (see Figure 3 above). However, demand for the currency will rise if a country has relatively better investment prospects because of, say, government incentives (see Figure 1 above).

 

Figure 4: Appreciation due to decrease in the supply of a currency

A graph showing appreciation due to decrease in the supply of a currency


Speculation

If the parties involved in the foreign exchange market believe the exchange rate will fall, they will sell more now, thereby increasing supply and causing a depreciation. However, if they are optimistic the exchange rate will rise, they will buy more now; currency demand rises and the currency appreciates.

 

Political or economic stability
A country with unstable government and harsh economic conditions will always discourage inflow of foreign investments and funds. There will be capital flight as investors seek safer and more conducive destinations  for their investments. Supply of the domestic currency will increase and its price will decrease.


Fixed exchange rate system

This is a system whereby the government maintains a fixed price for the currency. It is not allowed to fluctuate. The government will intervene whenever there is a change in currency demand or supply because it will  push the value above or below the predetermined rate.  The government can use its reserve of foreign currencies to buy the currency when the supply increases. This increases demand for the currency and brings the exchange rate back to the fixed value. In Figure 5 below, P1 is the fixed exchange rate while D1 and S1 are represent the demand and supply at that value. A sale of the currency owing to relatively lower interest rate, as an example, will increase supply from S1 to S2, thereby exerting a downward pressure on exchange rate from P1 to P2. The government would increase currency demand from D1 to D2 by buying it in the foreign exchange market. The exchange rate, as a result, goes back from P2 to the predetermined rate, P1

 

Figure 5: Government intervention when currency supply increases

A graph showing government intervention when currency supply increases


If demand for the currency rose from D1 to D2 as a result of growing demand for a country’s exports, the exchange rate will go up from the fixed rate of P1 to P2 (Figure 6 below). The government, however, responds by selling the domestic currency in the market thereby increasing its supply from S1 to S2. Therefore, the rate falls from P2 to P1 fixed by the government.

 

Figure 6: Government intervention when currency demand increases

A graph showing government intervention when currency demand increases


Alternatively, the government can raise interest rate to increase demand when increase in supply depresses the currency value below the predetermined value. It will lower interest rate to increase supply when a rise in demand raises the exchange rate above the fixed rate.

One advantage of adopting a fixed exchange rate is that the stability encourages investment and trade. It makes it easy for businesses to plan as there are no fluctuations that can result in exchange loss. This is why it is preferable to the floating exchange rate system. Another usefulness is that it ensures that government formulates responsible microeconomic policies in order to prevent the need to have to use its reserve to intervene in the foreign exchange market. For example, a relatively high inflation rate will decrease the demand for or increase the supply of the currency which would lower exchange rate; the government has to buy with foreign currency in order to restore to the originally fixed rate. So government maintains a disciplined approach to designing policies in order to keep inflation, for instance, under control.

The fixed exchange rate system requires a lot of funds in reserve for intervention purposes. The funds can used be used for other projects if the government does not use the fixed exchange rate system. And if the government opt for the use of a policy such as interest rate to maintain its already determined rate, increasing the interest rate is capable of discouraging borrowing, consumption and investment. This can reduce the employment rate and dampen economic growth. In addition, other countries can retaliate when a country does not allow its exchange rate to be determined by the market forces. Government intervention could make other country’s exports more expensive in the domestic market. The other countries will have to respond accordingly in order to protect their export revenue. 


Managed float

This system combines the features of both the floating and fixed exchange rate systems. The government selects upper and lower limits for the exchange rate. It will only intervene when a change in demand or supply will make the exchange rate higher than the upper limit or lower than the lower limit. In other words, fluctuation is only allowed as long as the exchange rate is within the established range. There is a fixed range and the exchange rate is not allowed to move out of it. The government still requires reserve to intervene when necessary. 

In Figure 7 below, the exchange rate is fixed between PU and PL. PU is the upper limit while PL is the lower limit. The exchange rate is P1 within the range fixed by the government. An increase in the supply of the currency from S1 to S2 will reduce the exchange rate to P2. But P2 is still within the range and there is no need for any form of intervention.

Figure 7: Managed float system when intervention is not required

A graph showing a managed float system when intervention is not required


In Figure 8 below, the increase in supply from S1 to S2 pushes the exchange rate to P2 below the lower limit PL. There is a need for government to buy the currency which will increase demand from D1 to D2; the exchange rate is restored to P1 within the target range.

Figure 8: Government intervention in a managed float system 

A graph showing government intervention in a managed float system