Exchange Rate Systems  Flexible Exchange Rates  If the government simply allows their currency to vary freely (i.e. does not implement a contractionary/expansionary money policy) then their exchange rates are floating  Advantage: market forces quickly eliminate shortages/surpluses  Disadvantage: if there are big changes in exchange rates, there are big risks for companies that import or export  EX. If the Canadian dollar suddenly appreciates, the price for Canadians purchasing an imported American product will increase and they will decrease their consumption of it

Fixed Exchange Rates  To avoid uncertainty caused by flexible exchange rates, governments often intervene in foreign exchange markets  When the gov’t sets a fixed exchange rate, it “pegs” the value of the country’s currency at a certain price in terms of another currency

Fixed Exchange Rates cont’d  Impact of Market Intervention  With fixed rates, the target value of the Canadian dollar can differ from the equilibrium determined by market demand and supply curves  A target level above equilibrium value produces a balance of payments deficit  A target level below equilibrium value produces a balance of payments surplus  More on next slide… Balance-of- payments Deficit Balance-of- payments Surplus

Fixed Exchange Rates cont’d  A target level above equilibrium value produces a balance of payments deficit  If the Canadian dollar is valued higher than the equilibrium value, then Canadians will buy more things, even though the market forces of demand and supply show that the value of the dollar is not so high  In a way, the country spent more money than it has, so the balance of accounts will show a deficit  The Bank of Canada fixes this by selling American currency and buying Canadian currency equal to the amount of the deficit

Fixed Exchange Rates cont’d  A target level below equilibrium value produces a balance of payments surplus  If the Canadian dollar is valued lower than the equilibrium value, then Canadians will buy less things, even though the market forces of demand and supply show that the value of the dollar is not so low  In a way, the country spent less money than it has, so the balance of accounts will show a surplus  The Bank of Canada fixes this by selling Canadian dollars to American currency in the amount of the surplus, so that the accounts once again balance

Exchange Rate Policy  Policy-makers use fixed exchange rates to affect domestic output and prices  Low Exchange Rates  Lowering the exchange rate serves as an expansionary policy  i.e. Canadian dollar is worth less  Country exports things cheap and imports things expensive  Risks: Danger of inflation; country’s trading partner may reduce their exchange rates to maintain their export markets  Currency returns to original value this way since both countries now have cheap exports

Exchange Rate Policy cont’d  High Exchange Rates  This makes importing things cheaper and the prices of Canadian exports rises  Raising the exchange rate = contractionary policy  Reduction in net exports and reduction in demand  Using a high-exchange rate as an anti-inflationary tool is also problematic  There’s still reduction in output and employment

Monetary Policy & Exchange Rates  The Bank of Canada can raise the exchange rate without ending up with a balance-of-payments deficit  It will just force interest rates up using contractionary monetary policy (decreases the amount the money in circulation)  Applying monetary policy in this way can complicate stabilization policy  This may damage the business cycle  The Bank must make sure its target value for the Canadian dollar allows the economy to move toward its potential output

Evolution of Exchange Rate Systems  The Gold Standard (1879 – 1934)  Each country set value of currency in terms of an amount of gold  e.g. Canadian dollar traded for grams of gold  This method broke down during Great Depression (1930s)  The Bretton Woods System (1945 – 1971)  Currencies could not naturally appreciate or depreciate  If gov’t faced constant surpluses, currency underwent devaluation  If constant shortages, currency underwent revaluation (increase)  Problem: a country cannot shield itself against foreign inflation  The IMF (International Monetary Fund) gives loans to countries that are running out of foreign currency to stabilize their currencies

Evolution of Exchange Rate Systems cont’d  Managed Float (1971 – Present)  Foreign value of currency is allowed to vary from day to day  Central banks still attempt to influence their countries’ exchange rates by buying and selling currencies  It is also known as “dirty float”