|Section 2: Flexible versus Fixed Currency Exchange Rate Systems|
|Macroeconomics - Unit 10|
Flexible Exchange Rate Systems
Depreciation and Appreciation
Depreciation and appreciation are changes in the values of currencies within a flexible exchange rate system.
If the supply of dollars increases, or the demand for foreign currencies increases relative to the demand for the dollar, then the value of the dollar falls. We say that the dollar depreciates.
If the demand for dollars worldwide increases, then the value of the dollar rises. We say that the dollar appreciates.
Some countries prefer to keep their currency values fixed relative to other foreign currencies. For example, if 100 units of a foreign currency exchange for $1, and the two countries decide to keep their currency values fixed for a period of time, we speak of a fixed, or pegged, exchange rate system. Through most of the 1990s China kept its currency fixed relative to most foreign currencies. Today China lets its currency fluctuate, even though the Chinese government still influences the rate at which it lets its currency fluctuate. No major industrial countries use a fixed exchange rate anymore in today's world economy.
Devaluation and Revaluation
In a fixed exchange system, if after a certain period of time, the government decides to "fix" its currency at a higher or lower value, then we speak of revaluation or devaluation respectively.
Advantages and Disadvantages of Fixed Exchange Rate Systems
In a fixed exchange rate system, the currencies are fixed for a certain period of time (for example, 6 months, or a year). An advantage for importers and exporters is that there exists more certainty for import and export businesses, tourists, or anyone else engaging in international trade, in knowing what the currency values are within this period of time. A disadvantage of a fixed exchange rate system is that the currencies usually do not have their true market value. Therefore, surpluses or shortages occur.
Advantages and Disadvantages of Flexible Exchange Rate Systems
In a flexible exchange rate system currency values change on a daily basis. The disadvantage is that this creates uncertainty for importers and exporters when it comes to planning for future trades. Note, however, that buyers and sellers of currencies can "hedge" against (protect themselves from) fluctuating exchange rates. If a U.S. business needs 1 million Japanese yen 2 months from today, then it can go to the currency futures market and buy the Japanese yen at a rate agreed upon today. This way, they fix the value of the currency they buy or sell for a certain period of time. Futures markets can, therefore, provide certainty regarding the future value of the currency even in a flexible system. Most economists, therefore, prefer a flexible exchange rate system over a fixed exchange rate system, because a flexible exchange rate system has the following advantages:
|Last Updated on Monday, 30 December 2013 10:29|