Exchange Rate Policies
Within countries there are three different types
of exchange rates:
Flexible
exchange rates
Fixed exchange rates
Mixed exchange rates
a) Flexible exchange
rate
A country's Central Bank does
not intervene with fixing the exchange rate, they leave it up
to the market, through the Law of offer and demand, which determines
the exchange rate, which will fluctuate with time.
If the Central Bank does not intervene
at any moment, we speak about "clean flotation" or
"dirty flotation".
The exchange rate will be in charge
of correcting the shortfalls and surplus of commercial balance
that could arise;
For example,
if there are shortfalls, that is to say they export
less than they import, then the demand on the national currency
will be weak and will start to loose value (their exchange
rate will depreciate). This will make imports increasingly
more expensive and the exports more competitive as they try
to overcome the shortfalls.
b) Fixed exchange rate
The Central bank fixes a determined
exchange rate and they are in charge of defending it, intervening
in the market and buying and selling currency.
Iif the exchange
rate starts to appreciate they will sell their currency (buying
currency), with the aim of increasing the monetary offer and
trying to prevent the exchange rate from increasing.
If the exchange
rate starts to loose value they will buy currency (selling
currency) to try and strengthen demand and prevent the exchange
rate from decreasing.
Sometimes when the Central Bank of
a country is trying to defend its exchange rate, they can use
up all of their reserves, which means they can no longer defend
themselves, which as a result means they are obliged to let
the exchange rate fluctuate naturally.
c) Mixed exchange rate
The Central Bank can establish
some limits within which they allow their money to fluctuate
freely, but if at some point in time the exchange rate dangerously
approaches the established limits, they will intervene to avoid
the money leaving the established limits.
For example,
Venezuela's Central Bank could establish a fluctuation
limit for the Bolivar taking into account the dollar. The
normal exchange rate is 950 bolivars/1050. They could fluctuate
freely except when they approach the marked limits in which
case they would intervene (let's see an example).
In general, Central
Banks try to ensure that their exchange rate maintains as stable
as possible:
If they appreciate a lot, it will
be difficult to export, which will mean a shortfall in commercial
balance and unemployment.
If they depreciate a lot, imports
will become more expensive, which will mean a strong recovery
of inflation.