The Impact of the Appreciation of the Chinese Currency - Dissertation Example

There are various exchange rate regimes which may be adopted by a country. A purely floating exchange rate regime is determined by the interactions of buyers and sellers in the international currency markets (Wong, 2005, Pp. 3 – 16). Countries which have declared that they will follow a fixed exchange rate regime make explicit attempts to maintain the value of their currency against other currencies, mostly the US dollar by intervening in the financial markets through their central banks.

Most countries, however, follow a regime that is somewhere in between the two previously mentioned extremes. A country may also state that it is following a certain exchange rate regime and in fact be doing something else altogether in order to protect its national interest. According to the Mundell Policy Trilemma, a state pursuing a stated exchange rate regime can only achieve two of the three goals which are desired when pursuing an exchange rate regime. The three desirable goals for a state pursuing a stated exchange rate regime are monitory autonomy, freedom of capital movement and exchange rate stability.

In a fixed exchange regime, there is stability of exchange rate and freedom of capital movement, but there is no monitory autonomy because the state has to constantly act in response to adjustments which have been made by others in the markets. A floating exchange rate regime has greater monitory autonomy because there is control of financial instruments by the state. The optimal currency area hypothesis or the OCA which was one of the earliest hypotheses explaining the adoption of a currency exchange rate regime and which was developed after the world had emerged from the Breton Woods System states that a small economy which trades internationally favours a fixed exchange rate regime as does an economy which conducts a large volume of trade.

A country which conducts trade with specific trading partners in a geographic region also benefits from a fixed exchange rate regime.