Rate of exchange refers to the rate at which one currency can be exchanged for another. When two countries are on the gold standard, the exchange rate will vary only between very low and very high rates.
Exchange
Rate and Adjustments:
Imbalances
in the balance of payments, deficits or surpluses, need adjustments sometimes
on internal and other times on external grounds. Adjustments depend on the system used for
this purpose. Adjustments are made using
one of the two polar options, namely, ‘floating’ and ‘fixed/pegged’ exchange
rates. Under the floating exchange rate
system, rate of exchange between the two currencies is determined by free
forces of demand supply. In the fixed
system, government’s intervention or any other mechanism is used to determine
the rate of exchange of setting the influences of demand and supply forces.
Floating Exchange Rates:
Determination
of rate of exchange between the currencies of two countries under free floating
system can be illustrated by the following diagram, in which America and Great
Britain exchange mutually USD and GBP.
The falling
demand for pounds shown by DD shows that the less expensive pounds for
Americans will make British goods cheaper.
Cheapness of the goods will increase the demand in USA and the Americans
will have more demand for GBP.
Curve SS in
the diagram depicts that as the dollar prices of pound rises or the pound price
of dollar falls, the British will purchase more US goods.
The dollar
price of pound is determined at point E ($2=£1). Where demand and supply curve for pound and
sterling intersect each other if the dollar price for pound increases (assume
from $2 to $3 = £1) the value of dollar will depreciate relative to the
pounds. Currency depreciation means that
it takes more units of a currency (here dollars) to buy a single unit of some
foreign currency (here pound).
Reciprocal will be the analysis if dollar price of pound is assumed to
be decreased. In other words,
appreciation of one currency means the depreciation of any foreign currency and
vice versa.
Determinants
of Floating Exchange Rate:
A question
of paramount importance arises here that why do the demand for and supply of a
particular currency varies or why does the rate of exchange vary in favour or
against? The change in the rate of
exchange under free floating system can take place because of the following
reasons:
1. Change in Tastes:
Change in
exchange rate is followed by the change in people’s tastes and preferences for
a product, esp. of commonly used product like technology. For example, if the
automobile technology of Japan appreciated in Great Britain, British will
supply more pounds to purchase dollars.
Consequently, the dollar’s value will appreciate and the rate of
exchange will move in favour of USA.
2.
Relative Income Change:
Rapid
growth of national income of a nation depreciates its currency against the
currencies of other countries because it imports vary directly with its level
of income.
3.
Relative Price Changes:
If the
prices in the domestic markets increase rapidly but remain constant in other
country, the local buyers will have more demand for low-priced countries’
goods. Importing country will have more
demand for the exporting country.
Consequently, the dollar’s value will depreciate.
4.
Relative Real Interest Rates:
If the
money supply, by tight money policy, is restricted, the real interest rate
increases in a particular economy.
Consequently, other country’s (e.g. Great Britain) firms and individuals
find it more profitable to invest in such country where the money supply has
deflated. As a result, the value of
currency of this country will appreciate.
5.
Speculations:
If it is
speculated that in country X, growth and inflation will be faster and real
interest rates will be lower in future as compared to country, the currency of
X will be expected to be depreciated and conversely the currency of Y will be
appreciated. Holders of X’s currency
will convert it into the currency of Y, increasing the demand for its currency.
Demerits
of Floating Exchange Rate System:
Freely
floating system, no doubt, works automatically but it can create some problems
also given as under:
1. Free
floating exchange rate system is highly uncertain which obviously
make the trade profits also uncertain.
Uncertainty discourages trade and so the volume of international trade
shrinks to minimum.
2. Decline
in the external value of local currency worsens the terms of trade
of a particular country. Consequently,
such a country will have to give more goods for the same imports.
3. Since
the fluctuating exchange rates depress the industry, which
produces the internationally traded goods, as a result, destabilizing
effects are casted on the economy.
Fixed Exchange Rates:
Fixed
exchange rate refers to the rate where the exchange rate between two or more
countries does not vary or at least varies only within narrow limits. It is also termed as pegging when the
monetary authorities of the country decide to maintain or peg the rate of
exchange of their currency at a fixed rate.
Fixed system, sometimes, is used to counter the disadvantages of
floating system.
The problem
of fixed exchange rate can be understood by an example illustrated in the
following diagram:
Pegging Methods:
The demand
for and supply of a foreign currency can be moved in favour as mentioned below:
1. Manipulation
of the market through the use of official reserves is the most
desirable method to peg the rate of exchange.
2. Trade
policies can also be utilised for pegging. For doing so flows of trade and finances are
controlled directly. Imports can be
reduced by imposing tariffs and quota system.
Similarly, special taxes may also be levied on nation who receives
interest or dividends on foreign investment.
But this option may decrease the volume of trade.
3. Exchange
rationing is another method.
Under this system, the government acquires the total foreign exchange
itself and so control the inflow and outflow of the foreign exchange. Under this option, all the local exporters
are required to sell their foreign exchange earned through exports to the
government. Then the government imposes
rationing on this stock of foreign currency.
4. The
final method of pegging is domestic macro adjustment. According to this method, local monetary and
fiscal policies are used to eliminate the shortage of the required foreign
currency.
Exchange
Control:
Exchange
control system is an antidote of free floating exchange rate system.
Objectives
of Exchange Control:
The main
objective of exchange control is to keep rate of exchange at a level different
than that of determined by free play of demand and supply forces in the foreign
exchange markets. Other objectives are
mentioned as under:
1.
Conservation of diminishing gold reserves in the country.
2. Ensuring
stable economic growth.
3. Correction
of an adverse balance of payments position.
4.
Maintenance of stable exchange rate.
5.
Prevention of flight of capital from the country.
6. Piling
up the foreign exchange reserves for paying large amounts, like repayment of
foreign aid.
Bretton
Woods conference’s major contribution was the establishment of International
Monetary Fund (IMF). It still
administers the international monetary system and operates as a central bank
for all the central banks. The member
nations subscribe by lending their currencies to the IMF; the IMF then relends
these funds to help the countries in balance of payments difficulties. The IMF has played a key role in organising a
cooperative response to the international debt crisis.
The members
of the IMF had first to announce the parity of their currencies, theoretically
in terms of gold, actually in terms of US dollars, after which there were to be
restrictions on changes of parity, although a change in value up to 10% could
be made merely by announcing this fact to the IMF. For a change greater than 10% permission had
to be given by the IMF, a decision having to be given within 72 hours when the
desired change was less than 2%.
One of the
objectives of IMF was to promote and stimulate multilateral trade, and it was
expected that all currencies would be made convertible after a short transition
period. It was hoped that the stability
of exchange rates associated with the gold standard, would be achieved but with
greater flexibility than that standard provided. The IMF created a pool from the contributions
of members, the amount of each country’s contribution depending on quota
assigned to it, 75% of the contributions being in its own currency and the
remainder being either in gold or partly in gold and partly in USD. The purpose of the pool was to enable a
country with a temporary deficit in its balance of payments to obtain from the
IMF foreign currency in exchange for its own up to a maximum of 25% of its
quota in only one year, but if at any time the IMF has a supply of a members
currency equal to double its quota, foreign currency can be obtained from the
Fund by the country concerned only in exchange for gold.
The member
country, facing imbalances on its balance of payments temporarily, is given a
period to put the things in order. In
1958, the IMF agreed to issue SDRs (Special Drawing Rights) to supplement
members’ reserves. After the
introduction of floating system, the importance of gold for valuation of the
currencies has been reduced. The IMF,
therefore, decided to sell most of its holdings of gold.
Source: Saeed Ahmed Siddiqui
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