Question

Using demand and supply curves to show autonomous exchange rate adjustment and exchange rate adjustment, compare the achievement of the equilibrium in the foreign exchange market.

Answer 1

- Although the pros and cons of fixed and flexible exchange rate regimes continue to be debated, regimes have been adopted that lie somewhere between these polar cases.

- In some cases, the driving force is the lack of credibility with respect to sound monetary policy.

- An economy with a history of hyperinflation may be forced to adopt a form of fixed- rate regime because its promise to maintain a sound currency with a floating rate regime would not be credible. This has been a persistent issue in Latin America.

- In other cases, the driving force is as much political as economic. The decision to create the euro was strongly influenced by the desire to enhance political union within the European Community, whose members had been at war with each other twice in the 20th century.

- A government’s control over the domestic currency’s exchange rate will depend on many factors; for example, the degree of capital controls used to prevent the free flow of funds in and out of the economy.

- Also, even under an “independent float” regime monetary authorities will occasionally intervene in foreign exchange markets in order to influence the value of their domestic currency. Additionally, the specifics of exchange rate policy implementation are subject to change

- In Independently Floating Rates the exchange rate is left to market determination and the monetary authority is able to exercise independent monetary policy aimed at achieving such objectives as price stability and full employment. The central bank also has latitude to act as a lender of last resort to troubled financial institutions, if necessary