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
Certainty of future value of
currency facilitates trade
2. Governments commit to
control inflationary policies
1.
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
1. Devaluation & Revaluation of Fixed XR Rates
–
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
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
AD
Value of
domestic
currency
Why?
Net
Exports
Real
GDP
Price
Level
Expansionary
Fall
Rises
Rises
Depreciates
Foreign 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
Rise
Rise
Contractionary
Rise
Falls
Falls
Appreciates
Foreign 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
Fall
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.