In our last article we talked about how central banks use official reserves (assets held by the central bank but in foreign currencies) to manage the value of their country’s currency, balance of payments, and overall monetary health. But reserves are just a single way for governments to achieve the aforementioned objectives. Another efficacious tool involves deliberately controlling your currency’s forex rates through exchange rate policies.
The purpose of implementing such measures often overlap with that of foreign reserves but also tie in with regulating unemployment and inflation, as is the case with several other monetary actions. Generally speaking, there are 3 main kinds of exchange rate policies:
Floating Exchange Rates
Adopted by 79 countries around the world, floating exchange rates allow the value of a currency to be dictated by the conditions of the forex markets such as interbank lending rates, the demand for a country’s exports, and the population’s average income (all of which we cover in our article introducing the forex markets). The obvious advantage of leaving currency valuations to supply and demand is that it factors in important information into these valuations. If a country engages in expansionary monetary policy and thus decreases the purchasing power of their currency, why should its exchange rate with other currencies not budge, particularly if those other currencies haven’t had a decrease in their purchasing power?
Advocates of floating rates argue that, within the context of foreign exchange, currencies must be seen as just another asset. If various factors deem that the value of this asset to be higher or lower than what it was a week ago, then so be it.
In the graph above, if the demand for the pound increases from D1 to D2 across the same supply curve S1 (meaning that the supply of pounds doesn’t change), then the price in terms of USD will also increase from Q1 to Q2. Demand goes up, ceteris paribus, so does the price.
But while these fluctuations may be seen as a good thing by proponents of floating exchange rates, they’re conversely seen as the actual problem by opponents. As exchange rates move up and down, not only exporters and importers may be afflicted but also banks, particularly those involved in international lending.
Assuming a 1:1 exchange rate between the USD and GBP, imagine that an American bank lends $1000 to a British firm with a 10% interest fee ($100) every year. Because they’re based in the UK, they convert their $1000 to £1000 so they can use it to expand operations, hire more workers, etc. All goes well in the first year and the borrowers are confident in their ability to generate the revenue necessary to pay back the loan. But then the demand for USD goes up such that its exchange rate with the GBP is 1:5. In other words, the firm has to now pay 5 times the amount of money in interest each year. No one foresaw this, and so the loan is now in default.
In this case, it’s almost entirely a lose-lose scenario. Not only is the company’s credit rating damaged, but they may also face an avalanche of additional costs and/or legal problems as punishment for failing to pay their loan, potentially ensuing them declaring bankruptcy. The bank, on the other hand, just lost what would’ve been a profitable investment and may not have ample money to fulfill their depositors’ withdrawals. If events such as this occur on a large enough scale, both sides will suffer.
Soft Exchange Rate Pegs
Pegging a currency essentially means that the government comes in and sets the exchange rate at a given point. A soft peg, also called a crawling peg, is where central banks will intervene if the exchange rate is moving too quickly in a given direction, but will otherwise leave the rates to market forces. Say that the market equilibrium for USD and GBP is 1:1, but the UK government decides that the optimal exchange rate range is $0.6-0.8 USD per pound, and so they decided to meet in the middle with $0.7 USD per pound. The market for GBP now looks something like this:
Point E is the uninterfered equilibrium point of exchange between the USD and GBP; every dollar will buy you a pound, meaning that EQ is how many pounds are demanded in terms of USD, so 1. The orange line represents the UK government setting the exchange rate at $0.7 USD per pound (keep in mind, however, that because we’re showing an example of a soft peg, that the exchange rate will be allowed to fluctuate between $0.6 and $0.8 USD per pound). QS and QD are the quantity supplied and quantity demanded, respectively, of the GBP after the soft peg policy was implemented. As shown in the diagram, pegging an exchange rate below the equilibrium, even if it’s allowed to fluctuate, will result in the quantity demanded exceeding the quantity supplied.
Likewise, the quantity supplied will exceed the quantity demanded if the exchange rate is softly pegged above equilibrium:
But exactly how do central banks “set” the exchange rate themselves? The 2 main mechanisms are through monetary policy and directly trading in the forex markets. An expansionary monetary policy (one wherein the money supply increases) and/or then using the newly-created funds to purchase other currencies would build up the supply and lower the demand for the currency in question, thereby depreciating its value.
But if the central bank wants to set the exchange rate above the market equilibrium, then they'll have to turn to a contractionary monetary policy (one wherein the money supply decreases) and/or use reserves of a foreign currency to buy its own currency from the forex markets. Both approaches would reduce the supply of and increase the demand for the currency in question, thereby appreciating its value.
Hard Exchange Rate Pegs
Essentially the more extreme version of the soft peg. While soft pegs allow the exchange rate to fluctuate by small amounts, hard peg policies attempt to maintain complete control over the exchange rate, precluding any and all market-driven fluctuation in the exchange rates. The principle reason for setting the exchange rate below the market equilibrium, whether through hard or soft pegs, is to boost exports. Lower exchange rates, ceteris paribus, increase the demand for whatever goods that country is exporting. As explained in our article introducing the currency markets, it’s basically because a depreciated currency would mean that the products are cheaper in terms of other currencies - lowered prices tend to increase demand.
Another reason for fixed pegs, again pertaining to trade, is to maintain stability. What do the USD and the euro have in common as currencies? They’re both historically stable and also belong to countries that are major players in the game of international trade. So if your country wants to maintain long-term trade relations with either Europe or the US, one way to solidify that affiliation would be to simply peg your currency to the USD or the euro. This ensures that not only your currency is stable (which is particularly important for developing nations as they often do not have the most reliable currencies) but also that American and/or European exporters are no longer as reluctant to trade with you since, even though they’re working with a foreign currency, it won’t be much trouble to handle as it’s pegged.
There are, however, a number of predicaments with fixed exchange rates. First off, if the country uses monetary policy (expanding or shrinking the money supply to raise or lower the exchange rate), that implies a shift away from the traditional focus of central banks, namely inflation and unemployment. If a country finds itself in a recession (requiring expansionary monetary policy) but can’t lower interest rates because that would in turn lower the currency’s exchange rate and breach the peg…what then? At least with a soft peg exchange rate there’s at least some room for central banks to sacrifice the peg in favour of countering the recession - no such opportunity exists with a hard peg.
The other problem is that fixed exchange rate policies could unintentionally bring about greater short-term fluctuations. How could this be the case? It all has to do with investor sentiment. With a fixed exchange rate policy, forex investors have their ears pierced for any bit of news concerning how and when the central bank may alter the exchange rates. Thus, even the tiniest of rumours could cause exchange rates to shift more violently than what could have been had the country instead adopted a free-floating exchange rate policy.
These effects are magnified under hard peg arrangements, where short-term fluctuations are curtailed. But then how could this result in short-term volatility? If the government starts out with a hard peg and then later wishes to abandon it, doing so (or even hinting that they might do so) could cause a dramatic shift in the exchange rate.
Econ IRL
Although the general consensus among economists is that trade liberalization increases the country’s productivity, the short-term effects of import competition (new market competition as a result of foreign firms exporting competing products into the country) haven’t been studied as much. This week’s paper analyzes the effects that import competition has on the economy’s short-term productivity and capital reallocation (firms redistributing and re-investing their financial resources in response to changing market conditions).
Observing manufacturing firms in Peru during 2000-2014, who took a substantial hit from Chinese import competition, the authors find that business’ reactions are contingent on the size of frictions (the cost of executing a financial transaction) in reallocating resources. Sometimes these frictions can be so great that, in the short-run, they result in a loss in domestic productivity. The reason is because large and established firms find it costly to reallocate investments and so they do what they can to linger, but this generates very steady productivity gains in the following years.
‘Till next time,
SoBasically