Exchange rate regulations and policies

by **claud39** Tue Jan 12, 2021 1:02 pm

Exchange rate regulations and policies

01/12/2021

In order to finance international trade and financial exchanges across borders, banks and financial institutions around the world exchange no less than $ 5 trillion in currencies every day in the foreign exchange markets. That amount represents about $ 600 for every person who lives on Earth. The currency exchange market is a market that is transacted 24 hours a day without stopping and almost universally.

Usually banks exchange their deposits in exchange for real large amounts of currency. For example, a US bank might exchange dollar-denominated deposits it has with deposits held by an Iraqi bank that are denominated in dinars.

In fact, the foreign exchange market is characterized as a hypothetical market (or what economists call across the table), meaning that most transactions in it take place between major banks through computer networks that link them instead of physical exchanges. Despite the enormous size of these exchanges, most of them are concentrated in limited places and within a relatively small number of currencies.

More than half of the world's foreign exchange exchanges involve financial institutions in the United States or the United Kingdom. About 85% of the exchanges are made using the US dollar, 39% of the euro, 19% of the Japanese yen, and 13% of the British pound sterling.

Exchange rate policies:

Different countries have different exchange policies for their currencies. Some countries, such as the United States and Canada, allow the exchange rate to be determined by the forces of the foreign exchange market, as is the case with the prices of most other goods and commodities.

Countries that take this approach have a floating exchange rate. Other countries prefer a fixed exchange rate, or what is also called a pegged exchange rate, between a country's currency and another country's currency. For example, Iraq has a fixed exchange rate of 1,450 dinars to the dollar. When countries adopt certain exchange rate policies, economists say there is regulation of the exchange market, or exchange rate regime.

Countries around the world usually follow one of three exchange rate regimes:

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[*]Fixed exchange rate system.

[*]Floating exchange rate system.

[*]Managed Floating Exchange Rate System (or Intermediate Exchange Rate System)

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In a fixed exchange rate system, the exchange rate is set at certain levels and maintained by the monetary authority in the country, i.e. the central bank. Historically, the two most important fixed exchange rate regimes were the gold cap and Bretton Woods system.

Under the gold cap system, which lasted from the nineteenth century to the thirties of the last century, countries ’currencies contained quantities of gold and paper currencies that governments committed to repurchase in exchange for gold if their holders so desired.

The gold cap system was a fixed exchange rate system because the currency exchange rates were determined by the amount of gold that each country had to cover its currency. Under the gold cap system, the size of a country's money supply depends on the amount of gold available. In order to achieve an expansion in the amount of currency used in the economy during periods of wars or economic recession, any country must abandon the gold cap system.

During the Great Depression in the thirties of the last century, many countries, especially the United States of America, decided to abandon the gold cap system in order to increase the flexibility of exchange rates for their currencies and to achieve greater control over the money supply.

However, some policymakers in several countries around the world are still calling for a return to the gold cap system, as US presidential candidate Ron Paul demanded in 2012 because he believes that the money supply should depend on something, gold, for example, so that the government does not control the money supply. Completely. But the truth is said that there are no serious attempts to return to the gold cap system for several reasons, including the great restrictions that this system places on the use of monetary policy to deal with economic recessions.

Towards the end of World War II, many economists and policymakers argued that a return to a fixed exchange rate regime would help the global economy to recover from the effects of fifteen years of depression and war.

The result of this was the Bretton Woods Conference in New Hampshire in 1944, which laid the foundations for a new exchange system in which the United States pledged to buy or sell gold at a fixed price of $ 35 per ounce. The central banks of the other countries that participated in the drafting of the Bretton Woods system pledged to sell or buy their countries ’currencies at a fixed exchange rate against the US dollar. By fixing the exchange rate of currencies against the dollar, these countries have practically fixed the exchange rate of their currencies against each other.

A fixed exchange system can face real problems because the exchange rate is not free to adapt quickly to respond to changes in the demand for currencies. By the early 1970s, the difficulties encountered in attempts to maintain a fixed exchange rate led to the collapse and then abandonment of the Bretton Woods system.

After the collapse of the Bretton Woods system, most countries of the world allowed their currencies to float, meaning that exchange rates became determined by the forces of buying and selling currencies in the foreign exchange markets.

However, some countries saw that the floating exchange rate regime that resulted from those operations led to much instability in exchange rates. As a result, some central banks intervened from time to time in order to influence the exchange rate of their countries' currencies by selling or buying currencies in the foreign exchange markets.

When the central bank of any country sometimes intervenes in the currency exchange market to affect the exchange rate, that exchange rate system is called the administered floating exchange rate system (or the intermediate exchange rate system).

Under this system, sellers and buyers in the foreign exchange market determine currency rates in most cases. Sometimes, with the intervention of the monetary authority. Many economists question the effectiveness of that intervention to determine the exchange rate by the monetary authority in relation to the currencies that are widely exchanged. For example, the Bank of Japan can try to influence the exchange rate between the Japanese yen and the US dollar by buying and selling quantities of the yen.

However, these operations are small compared to the total quantities bought and sold from these two currencies in the foreign exchange markets. Therefore, it is unlikely that the central bank will be able to influence the exchange rate through its intervention in the market for currencies that are widely exchanged for more than a short period.

Policy options in relation to exchange rate regimes:

Current exchange rate regimes reflect three options in countries ’policies:

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[*]The United States and other developed countries such as the United Kingdom, Canada, and Switzerland allow their currencies to float against other major currencies.

[*]Nineteen countries in Europe have adopted the euro as a single currency.

[*]Some developing countries fix the exchange rate of their currencies against the dollar or other major currencies.

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Since the collapse of the Bretton Woods system, the Federal Reserve (the central bank of the United States) has rarely intervened in the foreign exchange market in an attempt to influence the exchange rate of the dollar. As a result, we could see large fluctuations in the dollar’s exchange rate against other major currencies since 1973.

Because of this, countries that export their products to the United States argue that US monetary policy has made the dollar exchange rate unrealistically low. But it is well known that the Fed does not intentionally achieve a fixed exchange rate for the dollar.

What has now become known as the European Union began as an entity with the six European states signing the Treaty of Rome in 1957, and has grown to now include twenty-seven countries, including many of the formerly communist Eastern Europe. In 1999, the European Union decided to go ahead with a single currency, and on January 1, 2002, the euro currency was launched. By 2012, seventeen member states of the European Union, including all major economies in Europe except the United Kingdom, had adopted the euro. The European Central Bank was established in 1998.

Although the central banks of the member states of the European Union are still operating, the European Central Bank is responsible for monetary policy and the issuance of the European currency. The euro suffered great difficulties, especially in 2012, when its fate became unknown when some European Union countries, such as Greece, Spain and Ireland, began to suffer from severe financial crises and became unable to pay the debts of their governments.

Many developing countries have tried to keep their exchange rates fixed or pegged to the US dollar or other major currencies. A fixed exchange rate can provide significant benefits to a country that has trade links with the other country. When the exchange rate is fixed, business performance planning becomes much easier.

For example, if Iraq raised the exchange rate of the Iraqi dinar against the dollar, Iraqi companies that export goods to the United States might be forced to raise the prices of their dollar-denominated goods that they export to that country, leading to a decrease in their sales. Whereas if the dinar had a fixed exchange rate against the dollar, planning these Iraqi companies to perform their business would be much easier.

In the 1980s and 1990s, there was another reason for stabilizing the exchange rate for some countries. During that period, the influx of foreign investment to developing countries, especially the countries of the continent of Asia, increased dramatically. It is now possible for companies from countries such as South Korea, Thailand, Malaysia, and Indonesia to borrow dollars directly from foreign investors or indirectly from foreign banks.

For example, a Thai company might borrow dollars from a Japanese bank. If the company wanted to use that money to set up a new factory in Thailand, it would have to change those dollars into the equivalent in Thai currency, the baht. When the company starts selling the plant's production, it will get additional units of baht that it needs to exchange for dollars in order to pay the interest due on the loan.

The problem arises if the baht depreciates against the dollar. Suppose the exchange rate is 25 baht per dollar when the company borrowed the amount. In order for the company to pay the monthly interest on the loan, and let's say it is 100 thousand dollars, the company must buy those dollars at 2.5 million baht. If the baht exchange rate drops to 40 baht per dollar, the company will need 4 million baht to pay the monthly interest on the loan. These high payments could be a fatal burden for the Thai company. Therefore, the Thai government had strong incentives to avoid these problems by keeping the baht exchange rate constant against the dollar.

In the 1980s and 1990s some countries feared the inflationary consequences of the floating exchange rate regime. When the price of the local currency falls, the prices of imports rise.

If imports constitute a large part of the goods and commodities that local consumers buy, then a depreciation of the local currency may cause significant inflation. In the 1990s, a key component of Brazil and Argentina's anti-inflationary policy was to establish a fixed exchange rate for their currencies against the dollar. However, there are many difficulties to follow a fixed exchange rate system because the central bank must be constantly prepared to buy and sell local currency against the dollar or other hard currencies at a fixed price, which exhausts the hard currency reserves it has.

Suppose that the Central Bank decided to peg the Iraqi dinar to the dollar, as most Gulf countries do. If there were currency dealers who want to sell quantities of dinars in order to obtain more dollars than the amounts of dinars that other currency dealers want to buy against the dollar, then the Central Bank of Iraq will have to buy the surplus dinars in exchange for dollars from its cash reserve.

In the opposite case, the Central Bank of Iraq must buy the surplus dollar in exchange for Iraqi dinars. In real practice, central banks often find it real difficulties to maintain the peg for long periods because, ultimately, they will face a decline in their hard currency reserves. Another downside of a fixed exchange rate is that it cancels out an important means that countries can use to recover from recessions.

During a recession, the exchange rate can depreciate If the country were to adopt a flexible exchange rate, which would increase the country's exports and reduce its imports. In the past two decades, there were a number of countries around the world, including many countries in Asia, Africa and South America that adopted the fixed exchange rate system, but found it unsustainable, which led them to eventually abandon it.

The table below shows the advantages and disadvantages of the different drainage systems.

Exchange rate system	Preferences	Disadvantages
Fixed exchange rate	It makes it easier for businesses to plan to borrow in other currencies It is easy for a central bank to control inflation	It is very difficult to maintain Eliminates the possibility of a drop in the local currency exchange rate in recessions
Floating exchange rate	The monetary authority does not need to intervene The exchange rate is allowed to reflect the interaction of market demand and supply forces	It can make business planning difficult It could make inflation worse if import prices rise rapidly
Rounded floating exchange rate (intermediate exchange rate)	It allows for greater stability in the exchange rate than the floating exchange rate	Central bank intervention is likely to be ineffective in dealing with widely traded foreign currencies

* Professor of Economics and Political Science, Kansas State University, USA.

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