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Text . EXCHANGE RATE MECHANISMS If you're planning a holiday abroad, one of the things you won't forget to do is to buy some of the local c
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Text . EXCHANGE RATE MECHANISMS
If you're planning a holiday abroad, one of the things you won't forget to do is to buy some of the local currency. You will probably visit a few banks to see which one offers the best exchange rate. But holidaymakers aren't the only ones who are interested in exchange rates. Governments are watching them all the time. This is because a change in the exchange rate of the national currency can affect the whole economy. Interest rates, balance of payments and economic growth will all feel the effects of a change in exchange rates.
But can governments do anything about exchange rates apart from watch them? Well, yes, they can. They can use something called exchange rate mechanisms. These are ways to control the value of the national currency against other currencies. There are different types of mechanism, but they are all variations on two extreme mechanisms: free floating exchange rate and fully fixed exchange rate.
When a currency's exchange rate is free floating, the government doesn't try to control the price of the currency. Remember that, just like any other price, the exchange rate changes when demand and supply change. When governments allow the currency to be free floating, they are saying, 'let the market decide the price of our currency'. In contrast, a fully fixed exchange rate is strictly controlled by the government. For example, the UK government might decide that they want sterling to remain at a constant exchange rate against the euro of £1 = €1.50. This is sometimes called pegging. In this example, sterling is pegged against the euro at that rate, although in actual fact sterling is a free floating currency.
However, there is a problem. If demand on the money market rises for sterling, then the exchange rate will rise also. How can the government maintain the exchange rate they want? The only way is to change the level of supply of sterling on the money market. The government can increase the amount of sterling on the international market by selling it. This means they buy foreign currencies and sell sterling. Alternatively, if they want to increase demand for sterling, the government needs to reduce the supply on the money market. To do this, they sell their reserves of foreign currencies and buy sterling. This way, they keep the exchange rate (the price) of sterling at a constant rate.
So which system is best – fixed or floating? It depends on lots of things. Each system has its benefits and drawbacks. A free floating mechanism often makes it easier to keep a steady balance of payments. Also, the government can make any changes it wants to interest rates without worrying about the exchange rate (the market looks after that). On the other hand, a fixed rate mechanism makes industry feel more secure. They know what the value of their exports will be, and so they can plan for the future more easily. This is good for the local economy and for international trade.
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