Exchange rates

• Main exchange rate systems:

  • Free floating exchange rate
  • Managed floating exchange rate
  • Semi - fixed exchange rate
  • Fully fixed exchange rate
  • Currency board system
• Free floating exchange rates are set purely by market forces , currency appreciates and depreciates with no intervention by the central bank. Therefore currency value isnt a monetary policy target.
• Managed floating exchange rates are driven by the market forces, however the central bank may intervene by buying reserves to support a currency and selling to weaken a currency. Currency is a target of domestic monetary policy.
• Fixed exchange rates occur when the central bank peggs a currency to another stable currency such as the Euro. The central bank has to hold enough reserves to intervene in currency markets when needed to maintain the fixed currency peg.
• Advantages to a free floating market

  • No central bank intervention means there is no need for high levels of foreign exchange reserves
  • Market forces adjust the exchange rate efficiently
  • Monetary policy can be focused on inflation instead of buying reserves
  • Reduced chance of speculative attacks as currency value is determined by market forces.
• Disadvantages of floating exchange rates

  • Exchange rate volatility may be harmful for foreign direct investment if confidence is lost.
  • Smaller nations, largely primary sector exporters, may be more vulnerable
  • Can cause inflation, weak currency - imports more expensive, cost push inflation