1.

Exchange Rate Regimes

Exchange rate regimes: a rule governing policy toward the exchange rate

(1) Fixed and Floating Exchange Rates

1. Fixed exchange rate: when the government keeps the exchange rate against some
other currency at or near a particular target
2. Floating exchange rate: when the government lets the exchange rate go wherever
the market takes it
There are also other types

(2) How Can an Exchange Rate Be Held Fixed?

The equilibrium rate can be higher or lower than target

(a) Surplus of genos in FOREX push value of geno down
How can govt support value of geno without changing rate?
1. Soak up surplus of genos by buying own currency in FOREX
Exchange market intervention: govt purchase or sales of
currency in FOREX
Foreign exchange reserves: stocks of foreign currency that govt
maintain to buy their own currency on the FOREX
** Govt sell foreign assets to support currency through market
intervention
 ** Govt buy foreign assets to keep value of currency down
2. Shift the supply and demand curve by changing monetary policy
Raise geno interest rate increase capital flows increase
demand for genos reduce capital flows out of Genovia, reducing
supply of genos
Increase in interest rate increase in value of currency
3. Reduce supply of genos to FOREX by requiring domestic residents
who want to buy foreign currency to get license, give license only to some
approved transactions
Foreign exchange controls: licensing systems that limit the right
of individuals to buy foreign currency
(b) Shortage
Use same strategies in reverse

(3) The Exchange Rate Regime Dilemma

Strengths of fixed exchange rates
Allows international business to have great certainty about the value of currency
in business deals
Prevents countries from overindulging in inflationary policies which would
destabilize the exchange rate
Costs of fixed exchange rates
Country must keep large quantities of foreign currency on hand
Large stocks of foreign currency is a low-return investment and can lead
to large capital flows out of the country
If exchange rate is stabilized by adjusting monetary policy rather than
intervention, monetary policy diverts from other goals
Makes recession fight monetary policy less effective
Foreign exchange controls can distort incentives for trade and lead to
bureaucracy and corruption