Lesson 32 ª


 

 

 

 

 

   

 

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.