How Do Banks Set The Exchange Rate?

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Overview

Exchange of currencies in the current era of globalisation is a significant aspect of international economics. The governments along with central banks tend to deploy significant mechanisms to determine the rate of exchange for their domestic currency in comparison to the currency they chose to be pegged. This study evaluates the evolution of currency exchange methods, the system of pegs and the way central banks of the nations manage the exchange rates of their nations under given exchange rate mechanisms.

Currency Exchange In The Past

Exchange rates tend to be the price or value of the currency of a nation in the terms of the currency of another nation. The history of this could goes back to thousands of years when commodities like wine, pearls, rare stones, animals, etc. were used as a medium of exchange. Over the span of years, the currencies evolved and eventually, the exchange of goods and services among nation began on the basis of the currencies instead of commodities (Kallianiotis, 2013).  

It was 1930, when the Federal Bank of the United States of America set the value of a dollar pegged to gold, with one ounce of gold being equivalent to $35 USD. Eventually after the second world war, when the numerous nations dealt with severe inflation and fluctuations in the currency exchange rates a lot of nations based the value of their currencies in terms of US Dollar (Grabianowski, 2020). Initially in 1944, it was a fix exchange rate system in which 44 nations got together and pegged to US dollar in fixed rate regime. Since the US dollar becomes a reserve currency, its demand was high and central banks would have to often intervene for stabilising the rate. By 1967, the run on gold led the British pound to devalue significantly and in 1971, US stopped pegging USD to gold. Thus by 1973, the fixed rate collapsed for a lot of nations and floating rate was significantly adopted (Ghosh, Ostry, & Qureshi, 2015). Prior to present mechanism of market exchange rates, the currencies used to be either pegged to a fixed currency or commodities like gold. The mechanism of exchange rate used to be highly dependent on the market economics, which is the demand and supply of a currency in international market. While stronger currencies like US dollar or British Pounds grew stronger in this regime, the currencies of developing or underdeveloped suffered in terms of international exchange and exchange rates had capacity to fluctuate numerous times a day (Eun, Kim, & Lee, 2015).

Over time the regimes of fixed exchange rates and the floating exchange rates were developed that help the central banks of nations to develop a strategy to peg their currency to another stable currency. The exchange rate mechanisms further tend to allow the central banks to influence their domestic currency prices in the market of foreign exchange. The exchange rate mechanisms currently deployed by the central banks of the nation are more inclines to provide stability to the exchange rates of the domestic currencies, reducing the fluctuation in foreign exchange market to that there is smoother possibilities of imports and exports as well as a predictability for the investors. According to essay writing help in Oman experts the central banks of the nation manage the currency exchange by selecting the fixed or floating rates or pegging their domestic currency to a stable international currency (Straubhaar, 2015).

Mechanisms Of Currency Peg

The currency peg tends to be a system through which the central bank of the nation along with the finance ministry of the nation sets a specific rate for its currency in terms of another foreign currency or even a basket of foreign currencies. Pegging of domestic currency with another currency tends to stabilise the rate of exchange between the two currencies. This helps the businesses of the nation to have a long term predictability of the rate of exchange and conduct their business planning accordingly (Cavallo, Neiman, & Rigobon, 2014).

However, for central banks, currency pegs could also be a challenging task for maintaining the stability in exchange rates of the currency. While a realistic currency peg helps in reducing the uncertainty and further promote trade as well as boost in the income, on the other hand an over the low level of currency peg could lead to low level of domestic standard of living, further hurting the foreign business and subsequently creating trade tension with other nations in the purview of international trade. Also, if the pegging is artificially high, it can lead to over consumption of import products, lead to financial distresses like inflation etc.

For example, currently United States of America have the arrangement for exchange rates with around 40 nations, 14 of which tend to peg their currency on a fixed rate with USD. This was a much larger system under the Breton Woods Agreement, in which more than 60 nations had a fixed peg with USD. However, that system collapsed but US dollar still remains to be one of the popular choices of pegging the currency, with euro being the runner up, with almost 25 nations having arrangements to set their exchange rates (Amadeo, 2020).

How Central Banks Manage Currency Pegging?

Suppose a nation has arrangements with the United States for pegging their currency. In this case, the central bank of the nation use the US dollars held by them to make purchases is UD Treasury. This helps the central banks to receive interest on the dollars held by them. Further the central bank of the nation monitors the demand its nation (the individuals and businesses) make for the US dollar for importing some goods, and the US dollars it is able to earn by export goods and earning US currency. On the basis of decided arrangements of the peg, the bank monitors the ongoing exchange rate. In case the currency falls below peg, the bank can intervene to raise the value of domestic currency. The bank could do this by selling the US Treasuries in secondary markets which provides the central bank with the cash to invest in local currency. Adding the supply of US Treasury in local market reduces the supply of local currency in market, restoring the balance of the peg (Goodhart & Lee, 2013). To know more take assistance from assignment help in Oman professionals.

Now, given that value of dollar is also projected to changes constantly, instead of opting of a fixed exchange rate in the pegging arrangement, the central banks of the nation can option for floating (or flexible) exchange rate system, to brace their domestic currency from the impact of the fluctuations in the foreign currency, to which they are pegged to (Towbin & Weber, 2013).

How Central Banks Set Exchange Rates In Fixed Rate Mechanism?

The Fixed rate system of exchange rates is those in which the central bank enters into a pegging arrangement of fix rate of exchange of a unit of their domestic currency against the units of international currency. Thus under the aspects of a fixed rate regime which is applied by the central bank of the nation, the officials enter an agreement of a fixed exchange rate of unit of their currency either with the units of another currency of in exchange of commodity like gold. The system keeps the value of the currency of domestic nation in the purview of a narrow band in the international market. However, fixed rate tends to provide a greater certainty to the importers and exporters in the nation, so the countries that are highly dependent on the fixed rate if their aim is to reduce the level of inflation and maintain the stability in the internal economy.

Central banks in this case decide a monetary policy of the nation which is dependent on a fixed exchange rate in the international economy. In this case, suppose a currency has been pegged to dollar in fixed exchange rate regime. In case the value of dollar fluctuates, the central bank would have to adjust the monetary policy to ensure that the fluctuations do not impact the internal economy. This implies that fluctuation in international market can simply be solved by devaluation of the currency to ensure the stability in the internal economy (Terra, 2015).

However, here is the point where central banks face challenges in maintaining the fixed rate regime. It can be highly detrimental to international trade of the nation, as devaluation of the currency makes it weaker for exchange in the international market, which implies that imports could get much dearer.

As mentioned by university assignment help experts, the US dollar was pegged to gold, a lot of nations found them to be stable to be pegged to the US dollar for some time. However, the system collapsed later and the central banks of the nations were able to peg themselves with other currencies like Euro or Yen on a fixed or floating regime. Although, given the benefits that fixed exchange rate system offers, despite its reservations, some of the nations like Qatar, Oman, Saudi Arabia, Panama, Hong Kong, Cuba, etc. (Goodhart & Lee, 2013)

Figure 1: Equilibrium above the fixed rate
Source: (Sanandres, 2021)

In the above figure, the reflected equilibrium is above the rate, which reflects that there is likely of shortage of national currency in the agreed rate. Since the rate is fixed and central bank likely cannot change the exchange rate to establish equilibrium. Online assignment help experts said the government could have to intervene and sell their currency from foreign exchange reserves to purchase the overseas currency. This would lead to shift in supply cure from S to S2, fixing the disequilibrium as their holdings for foreign currency would rise (Sanandres, 2021).

Figure 2: Equilibrium below the fixed rate
Source: (Sanandres, 2021)

The figure 2 represents the case when the equilibrium of exchange reaches below the level of fixed rate, which implies that there is a surplus of national currency. In this case the government would be to purchase this surplus currency to control inflation and further prevent the domestic currency from falling. So, the foreign reserves would fall, but demand for domestic currency would rise from D to D2 (Sanandres, 2021).

How Central Banks Set Exchange Rates In Floating Rate Mechanism?

If the central bank chooses to peg the currency under the floating rate exchange system, it leads to determination of exchange rate through the market mechanisms of demand and supply of currencies, both the domestic currency and the currency to which it is pegged. Thus, in this case, if the demand of given currency is high; its value will further rise, while of its demand fall, the price of exchange for currency would also go down.

Wider the fluctuations would be in the currencies in the terms of international trade, more detrimental it would be for the economic balance of the nation and stability of its currency. This often leads to issues like inflation, which the central banks regularly monitor through internal monetary policy tools and ensure that internal stability is maintained. As per assignment makers The central banks intervene in currency markets through mechanisms of lowering or raising the level of rate of interest to impact the flow of investors and subsequently affect the demand of currencies and thus controlling the exchange rate.

Figure 3: Floating exchange rate mechanism
Source: (CFI, 2021)

In the above figure, it is evident that market sentiment for the economy in the international exchange market affects the strength or weakness of the currency in the floating exchange rate regime. The central bank and finance ministry can intervene through mechanisms to increase the demand or supply of the currency, leading to its appreciation or depreciation which could maintain a certain level of exchange providing stability to importers and exporters (CFI, 2021). To know more about Floating rate mechanism, take instant assignment help from OmanEssay.

Conclusion

 In this study the exchange rate mechanism for currencies has been discussed, the central banks of nations play a significant role in maintaining a stable rate of exchange in case of fluctuations of demand and supply of currency. The fixed exchange rate and floating exchange rates are the two most commonly deployed techniques that are deployed by different nations to ensure the exchange rate in the international market.

References

Amadeo, K. (2020). The Dollar Peg, How It Works and Why It’s Done. Retrieved from https://www.thebalance.com/what-is-a-peg-to-the-dollar-3305925

Cavallo, A., Neiman, B., & Rigobon, R. (2014). Currency Unions, Product Introductions, and the Real Exchange Rate. The Quarterly Journal of Economics , pp. 529 – 595.

CFI. (2021). What is a Floating Exchange Rate? Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/economics/floating-exchange-rate/

Eun, C., Kim, S., & Lee, K. (2015). Currency competition between the dollar and euro: Evidence from exchange rate behaviors. Finance Research Letters , pp. 100 -108.

Ghosh, A., Ostry, J., & Qureshi, M. (2015). Exchange Rate Management and Crisis Susceptibility: A Reassessment. IMF Economic Review , pp. 238–276.

Goodhart, C., & Lee, D. (2013). Adjustment Mechanisms in a Currency Area. Open Economies Review , pp. 627 – 656.

Grabianowski, E. (2020). How Exchange Rates Work. Retrieved from https://money.howstuffworks.com/exchange-rate.htm

Kallianiotis, J. N. (2013). History of Exchange Rate. Exchange Rates and International Financial Economics , pp. 1 – 50.

Sanandres. (2021). Fixed exchange rates. Retrieved from http://www.sanandres.esc.edu.ar/secondary/economics%20packs/international_economics/page_55.htm

Straubhaar, T. (2015). Should Central Banks Manage the Exchange Rate? Retrieved from https://www.intereconomics.eu/contents/year/2015/number/3/article/should-central-banks-manage-the-exchange-rate.html

Terra, C. (2015). Exchange Rate Regimes. Principles of International Finance and Open Economy Macroeconomics , sciencedirect.com/topics/economics-econometrics-and-finance/fixed-exchange-rate.

Towbin, P., & Weber, S. (2013). Limits of floating exchange rates: The role of foreign currency debt and import structure. Journal of Development Economics , pp. 179 – 194.

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