Exchange Rate Regimes Because governments set quantity of money, they have significant influence on exchange rates, which in turn is important to net exports Exchange rate regime: a rule governing policy towards the XR Options for policy: 1. Fixed exchange rate – gov’t keeps at/near a target 2. Floating exchange rate – gov’t lets XR follow market 3. Compromise policies that lie somewhere in between

Fixed Exchange Rate How governments keep exchange rates at a fixed rate When equilibrium value is below target: 1. Governments can buy up excess currency (exchange market intervention) with foreign exchange reserves 2. Governments can implement policy to raise interest rates 3. Governments can use regulation (foreign exchange controls) to limit amount to foreign investors who want to sell the currency Opposite options when equilibrium XR is above target

The XR Regime Dilemma Benefits of fixed rate Benefits of floating rate 1. Certainty of future value of currency facilitates trade 2. Governments commit to control inflationary policies 1. No need to keep large stores of foreign currency 2. Use of monetary policy to stabilize XR may conflict with other goals 3. Foreign exchange controls distort trade balance

3 Policy Issues of Open-Economy Devaluation of Fixed ER Revaluation of Fixed ER Depreciation due to revision of fixed ER target Increases current accounts Used to eliminate shortages in FOREX Increases AD Appreciation due to revision of fixed ER target Decrease current accounts Used to eliminate surpluses in FOREX Decreases AD 1. Devaluation & Revaluation of Fixed XR Rates –

3 Policy Issues of Open-Economy 2. Monetary Policy & Floating XR Rates – Monetary policy to lower interest rate will encourage investment spending & consumer spending, but also affects FOREX Decreases capital flow into country & lowers demand for currency Result is depreciation of currency & increase in AD

3 Policy Issues of Open-Economy 3. International Business Cycles – Demand shocks from abroad can impact other countries due to reduction in demand for imports Floating rate allows depreciation of currency when foreign demand falls Increased net exports limit effect on AD

Effects of Monetary Policy on FOREX Monetary Policy Interest rates Domestic investment ADValue of domestic currency Why?Net Exports Real GDP Price Level ExpansionaryFallRises DepreciatesForeign investors seek nations with higher interest rates on financial assets, thus decreasing the demand for the currency. Domestic investors seek nations with higher interest rates on financial assets, thus increasing the supply of the currency. Rise ContractionaryRiseFalls AppreciatesForeign investors seek nations with higher interest rates on financial assets, thus increasing the demand for the currency. Domestic investors seek nations with higher interest rates on financial assets, thus decreasing the supply of currency. Fall

Key Concepts The exchange rate for a nation’s currency can be influenced by government policy. If the fixed rate is above the market equilibrium rate, there is a surplus of that nation’s currency in the foreign exchange market. There are typically three ways in which the government can reduce the price to reach the target exchange rate. Likewise, if the fixed rate is below the market equilibrium rate, there is a shortage of that nation’s currency in the foreign exchange market. There are some advantages to a fixed exchange rate regime, but also disadvantages. Nations like the U.S. and Canada have determined that a floating exchange rate policy is superior to the fixed exchange rate policy

Key Concepts A nation can intentionally devalue the currency through expansionary monetary policy. A decrease in interest rates causes a decrease in the demand, and an increase in the supply, of the currency, thus making the currency depreciate. This can have the effect of increasing net exports and increasing real GDP. A nation can intentionally revalue the currency through contractionary monetary policy. An increase in interest rates causes an increase in the demand, and a decrease in the supply, of the currency, this making the currency appreciate. This can have the effect of decreasing net exports and decreasing inflation. A floating exchange rate can insulate a nation from recession that begins overseas.