Fixed Exchange Rate Systems
Fixed exchange rate systems are monetary arrangements where the value of a country’s currency is fixed to another currency or a basket of currencies. This means that the exchange rate between two currencies remains constant over time. There are several types of fixed exchange rate systems, including currency pegging, crawling peg system, and currency board arrangements.
Currency Pegging
Currency pegging is a form of fixed exchange rate system where a country’s central bank sets an official exchange rate for its currency against another major currency, such as the US dollar or the euro. The central bank then intervenes in foreign exchange markets to maintain this fixed exchange rate by buying and selling its own currency.
One advantage of currency pegging is that it provides stability in international trade by eliminating uncertainty about future exchange rates. It can also help control inflation by restricting the ability of the domestic central bank to print money and expand credit excessively.
However, maintaining a fixed exchange rate can be challenging because it requires significant foreign reserves to intervene in forex markets. If market forces exert pressure on the pegged currency, such as speculation or changes in economic fundamentals, it may become difficult for the central bank to defend the fixed rate.
Crawling Peg System
A crawling peg system is a variation of a fixed exchange rate regime where the official exchange rate is adjusted periodically based on specific criteria determined by policymakers. This allows for some flexibility while still providing stability compared to floating exchange rates.
Under this system, countries typically adjust their currencies’ values at regular intervals based on factors like inflation differentials with trading partners or changes in real effective exchange rates (REER). By adjusting gradually over time, countries aim to achieve competitiveness without sudden shocks to their economies.
Currency Board Arrangements
Currency board arrangements are another type of fixed exchange rate system characterized by strict rules and limitations set forth by legislation. In these systems, central banks must hold sufficient foreign reserves equaling 100% or more of the domestic currency issued.
This arrangement is designed to provide credibility and confidence in the stability of a country’s currency. The central bank can only issue new money when it has enough foreign reserves to back it up. As a result, inflationary pressures are limited, and there is a strong commitment to maintaining the fixed exchange rate.
Dollarization
Dollarization occurs when a country adopts another country’s currency as its legal tender, most commonly the US dollar. This eliminates the need for an independent monetary policy and exchange rate regime since the dollar becomes the de facto currency.
The benefits of dollarization include increased stability, reduced inflationary pressures, lower transaction costs in international trade, and enhanced access to global financial markets. However, dollarized economies may face challenges related to loss of control over monetary policy and susceptibility to economic shocks from the issuing country (in this case, the United States).
Exchange Rate Pass-Through
Exchange rate pass-through refers to how changes in exchange rates affect import and export prices. When a country’s currency depreciates relative to other currencies, imported goods become more expensive while exported goods become cheaper.
The extent of exchange rate pass-through depends on various factors such as competition levels in domestic and international markets, input costs sensitivity to exchange rates, pricing strategies adopted by firms, and government policies like tariffs or subsidies.
Purchasing Power Parity (PPP)
Purchasing power parity (PPP) is an economic concept that suggests over time; exchange rates should adjust so that identical baskets of goods have equal purchasing power across different countries. In simpler terms, PPP implies that if one unit of a given currency buys more goods in one country than another currency does in another country after adjusting for exchange rates.
PPP theory suggests that currencies with relatively high inflation rates will tend to depreciate over time compared to currencies with low inflation rates until price levels align between nations. However, empirical evidence shows mixed results regarding the validity of PPP, as several factors can affect exchange rates and prices in the short term.
Real Effective Exchange Rate (REER)
The real effective exchange rate (REER) is a measure that adjusts a country’s nominal exchange rate to account for inflation and trade competitiveness with its trading partners. It provides insight into whether a country’s currency is overvalued or undervalued relative to others.
A higher REER indicates that a country’s goods are relatively expensive compared to its trading partners, making its exports less competitive and imports more attractive. Conversely, a lower REER suggests increased competitiveness in international markets.
Exchange Rate Volatility
Exchange rate volatility refers to the degree of fluctuation in currency values within a given period. High levels of volatility can create uncertainty for businesses engaged in international trade or foreign investments because they introduce risks related to pricing, profitability, and cash flows.
Various factors contribute to exchange rate volatility, including economic fundamentals like interest rates and inflation differentials, geopolitical events, market sentiment, speculation activities by traders and investors, government policies on foreign exchange markets intervention, among others.
J-Curve Effect on Trade Balance
The J-curve effect describes an economic phenomenon where there is an initial deterioration followed by an improvement in the trade balance after a currency depreciation.
Initially, when a currency depreciates against other currencies, it becomes more expensive for importers as their purchasing power decreases. This leads to higher import costs which may take some time before being passed onto consumers through higher prices. Consequently,
the volume of imports tends not to decrease significantly immediately after depreciation.