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Exchange Rate Regimes - Essay Example

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Consequently, exchange rates are very sensitive to the receipt of new information (Swan, 1993, p 67-69).
The large and sustained changes in nominal and real exchange rates were among the most significant developments in the world economy in the 1980s. For example, in the first half of the decade, the US dollar appreciated by about 40 per cent against most other major currencies and then, in the second half of the decade, declined, reversing all the previous appreciation. These changes gave rise to international pressures associated with rapidly changing competitiveness of exports; intervention by central banks in foreign exchange markets; and intense debate regarding the extent to which these exchange rate changes interact with current account imbalances.
The ultimate purpose of economics is to increase economic welfare. So far we have concentrated almost entirely on the optimal allocation of a given bundle of resources, but it is obvious that welfare may also be improved either by increasing the quantity of resources available or by learning to do more with a given bundle. Both of these possibilities represent economic growth-the first through factor augmentation and the second through technical progress. Some economists feel that conventional measures of economic growth based on the output of goods and services (gross national product) do not satisfactorily reflect economic welfare, arguing that they ignore factors such as pollution and the negative externalities from congestion. We shall ignore this controversy here, however, and assume that increased productive capabilities represent improved opportunities for economic welfare (Markham, 1987, p 156-160)).
Exchange rate regimes
The exchange rate-the price of foreign currency-is determined by supply and demand. The demand for foreign currency arises from debit items on the balance of payments, i.e. from spending abroad; the supply arises from credit items. Any tendency towards surplus on the balance of payments creates an excess supply of foreign currency, driving down its price in terms of domestic currency or driving up (appreciating) the value of domestic currency in terms of foreign currency (Baxter, Marianne, Alan C., 1988, p 187-192). Hence if, at any given exchange rate, credits exceed debits, the exchange rate is forced above that level. Equilibrium can occur only where excess supply is zero, i.e. where credits equal debits, and the exchange rate must move to bring this about.
There are two polar ways of bringing about this equality. First, under a system of perfectly flexible exchange rates (or 'clean floating'), the monetary authorities keep out of the foreign exchange market entirely. Official finance is thus set to zero, and the balance of the remaining accounts must also be zero, since total credit and debits are equalized. For such a market to be useful it must be stable: the excess supply of foreign currency must be eliminated by the appreciation of the home currency that it induces. In the long run this occurs through items in the basic balance. An appreciation of sterling raises the dollar price of goods and assets priced in sterling. Hence British goods and assets lose ...Show more
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Summary

The impact of the inherent volatility and unpredictability of exchange rates on macroeconomic conditions is central to the debate about fixed and flexible exchange rates. Real exchange rates are defined as nominal rates adjusted for price levels. Since prices for individual countries, when expressed in a common currency, are subject to the variability of exchange rates, bilateral real exchange rates based on individual-country price levels may be infected with measurement errors…
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