III. Exchange Rate Policy

Because the exchange rate is the price of a country’s money, governments and central banks must have a policy toward the exchange rate. Three possible exchange rates policies are.

Flexible Exchange Rate

• A flexible exchange rate policy permits the exchange rate to be determined by demand and supply with no direct intervention by the central bank. Even so, the exchange rate is influenced by the central bank’s actions. For instance, if the Fed raises the U.S. interest rate, the U.S. interest rate differential increases, which appreciates the U.S. exchange rate. Most countries, including the United States, have flexible exchange rates.

Fixed Exchange Rate

• A fixed exchange rate policy pegs the exchange rate at a value determined by the government or the central bank and blocks the unregulated forces of supply and demand by direct intervention in the foreign exchange market. A fixed exchange rate requires direct and frequent intervention by the central bank.

· If the demand for dollars decreases or the supply of dollars increases, to fix the exchange rate the Fed buys U.S. dollars. By so doing the Fed increases the demand for dollars and raises the exchange rate. But the Fed cannot pursue this policy forever because it eventually will run out of the foreign reserves it is using to purchase the dollars.

· In the figure the demand for dollars has decreased from D₀ to D₁. To keep the exchange rate fixed at 100 yen per dollar, the Fed needs to buy 2 billion dollars per day, the difference between the quantity of dollars supplied at the fixed exchange rate (7 billion dollars per day) and the [new] quantity of dollars demanded (5 billion dollars per day). To purchase these dollars the Fed must use its foreign reserves. Ultimately the Fed will run out of foreign reserves and when that takes place the Fed can no longer peg the exchange rate at 100 yen per dollar.

· If the demand for dollars increases or the supply of dollars decreases, with no intervention the exchange rate will rise. To fix the exchange rate the Fed sells U.S. dollars so that it increases the supply of dollars and lowers the exchange rate. But the Fed will accumulate large stocks of the foreign reserves it is accepting in payment for the dollars. The People’s Bank of China pursued such a policy to hold down the value of the yuan and while so doing accumulated billions of dollars of U.S. dollars.

Crawling Peg

• A crawling peg policy selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate only the target value changes. The target changes whenever the central bank changes. China is now currently using a crawling peg exchange rate policy for the yuan.

The People’s Bank of China in the Foreign Exchange Market

• From 1997 until 2005, the People’s Bank of China fixed the Chinese exchange rate by selling yuan and buying dollars to offset the effects of increases in the demand for yuan. China accumulated foreign currency reserves of almost $1 trillion by mid-2006, and by the end of 2007 was fast approaching $2 trillion.
• Since 2005, the People’s Bank has allowed the yuan to crawl upward. Even so the yuan has not risen to its equilibrium level, hence the People’s Bank must buy U.S. dollars to hold the yuan/dollar exchange rate down.
• China most likely fixed its exchange rate to anchor its inflation rate so that it does not deviate much from the U.S. inflation rate. The Chinese inflation rate departs from the U.S. inflation rate by an amount determined by the speed of the crawl.

Date: 2015-12-11; view: 710