Comments on: How do some countries manage a fixed exchange rage? http://dwarfprinting.com/269/how-do-some-countries-manage-a-fixed-exchange-rage/ Big Printing For Little Companies Sat, 19 May 2012 03:17:51 +0000 http://wordpress.org/?v=2.7 hourly 1 By: I didn't do it! http://dwarfprinting.com/269/how-do-some-countries-manage-a-fixed-exchange-rage/comment-page-1/#comment-875 I didn't do it! Fri, 25 Dec 2009 10:27:31 +0000 http://dwarfprinting.com/269/how-do-some-countries-manage-a-fixed-exchange-rage/#comment-875 In a fixed exchange rate regime, the government is committed to intervene in the foreign exchange market to ensure that its own currency is maintained at the published level against the reference currency, for example the US$. A fixed exchange rate regime has certain advantages: it makes international trade and investment easier and cheaper because it removes the foreign exchange risk and the costs of hedging. However, there is a major downside: consider a country with a trade deficit, let's say with its major trading partner the US. The imports are higher than the exports, this means that the demand for US$ tends to put pressure on the price of the domestic currency. To maintain the exchange rate at the predefined level, the government must intervene in the foreign exchange market and buy domestic currency by selling US$. This would lead to a loss of foreign currency reserves and a contraction of the domestic money supply, leading to a fall in salaries and prices (deflation) until equilibrium is restored. Once the foreign currency reserves are used up, the government will be forced to devalue the domestic currency. The opposite happens when the country has a trade surplus against the US: the government has to intervene in the foreign exchange market to by selling domestic currency to maintain the fixed exchange rate. The higher supply of money will put upward pressure on domestic prices (inflation). In a fixed rate regime, the government in fact loses control over the domestic economic policy and is open to speculative attacks: if speculators perceive that the value of the domestic currency is not at the market equilibrium, they will attack the exchange rate, betting against the government, assuming that the government will run out of foreign currency reserves and will have to adjust the fixed exchange rate to the market price. This is what happened to the Hong Kong $ during the Asian crises in 1997. In this case, however, it turned out that the Hong Kong Monetary Authority had sufficient levels of currency reserves to fight off the speculative attacks (by George Soros) and was therfore able to maintian the fixed exchange rate against the US$. In a fixed exchange rate regime, the government is committed to intervene in the foreign exchange market to ensure that its own currency is maintained at the published level against the reference currency, for example the US$. A fixed exchange rate regime has certain advantages: it makes international trade and investment easier and cheaper because it removes the foreign exchange risk and the costs of hedging.

However, there is a major downside: consider a country with a trade deficit, let’s say with its major trading partner the US. The imports are higher than the exports, this means that the demand for US$ tends to put pressure on the price of the domestic currency. To maintain the exchange rate at the predefined level, the government must intervene in the foreign exchange market and buy domestic currency by selling US$. This would lead to a loss of foreign currency reserves and a contraction of the domestic money supply, leading to a fall in salaries and prices (deflation) until equilibrium is restored. Once the foreign currency reserves are used up, the government will be forced to devalue the domestic currency. The opposite happens when the country has a trade surplus against the US: the government has to intervene in the foreign exchange market to by selling domestic currency to maintain the fixed exchange rate. The higher supply of money will put upward pressure on domestic prices (inflation).

In a fixed rate regime, the government in fact loses control over the domestic economic policy and is open to speculative attacks: if speculators perceive that the value of the domestic currency is not at the market equilibrium, they will attack the exchange rate, betting against the government, assuming that the government will run out of foreign currency reserves and will have to adjust the fixed exchange rate to the market price. This is what happened to the Hong Kong $ during the Asian crises in 1997. In this case, however, it turned out that the Hong Kong Monetary Authority had sufficient levels of currency reserves to fight off the speculative attacks (by George Soros) and was therfore able to maintian the fixed exchange rate against the US$.

]]>