This article seeks to
conscientize the public on the types of exchange rates, their advantages, and
disadvantages and why monetary policy authorities prefer one over the other. A
country can so choose which exchange rate to use depending on the nature and characteristics
of that country. It is worth noting that there is no “one size fits all”
approach, as economies exhibit different characteristics or features. My
previous article looked at money and its economic functions, and in this
article, I need to illustrate the point that money used in a country is called
the currency of that country. Currency simply refers to notes and coins that
are the current medium of exchange in a country. These currencies are exchanged
on the foreign exchange market, but an interesting question is what determines
the rate at which they exchange for one another? It is the forces of supply and
demand which determine the price of one currency in relation to other currencies.
But one would ask the question -What is an exchange rate?
Exchange Rate defined
The exchange rate can be defined as the relationship at which one currency can be exchanged for another currency. The rate is expressed as the amount of one currency that is necessary to purchase one unit of another currency (e.g., 1US$ =ZAR 15 and in our case, 1US$ ≈ 85RTGS-Basing on the foreign currency Auction Rate).
Types of Exchange Rates
a) Free, fluctuating or floating exchange rate
This means the existence of a free or competitive foreign exchange market where the price of one currency in terms of another is determined by the forces of demand and supply operating without any official interference.
b) Managed Exchange Rates
Although market forces are the main determinant of floating exchange rates, there are times when central banks try to influence the market rate. Governments do this by adjusting interest rates or by intervening directly in the foreign exchange market i.e., by reducing or increasing foreign exchange reserves. If the central bank does not intervene in the market, it is described as clean floating and if the central bank does intervene, it is described as dirty floating. Since floating exchange rates can sometimes overshoot due to forces of supply and demand, they can create some imbalances which can result in exports being halved or doubled – some official intervention in the foreign exchange market may be designed to offset the overshooting to some extent.
c) Fixed Exchange Rates
In a typical fixed exchange rate system, the countries must fix the values of their currencies in terms of common standards. To maintain currency at a fixed value, the monetary authorities of a country must stand ready to buy and sell the currency at a fixed price. This means that they must have large supplies of their currency, gold, and convertible currencies i.e., foreign reserves to remove any excess demand or supply at the fixed price.
Terms to Note
Revaluation versus Devaluation
Revaluation involves deliberate action by
monetary authorities to move the exchange values of their currencies to higher
parities. Revaluation makes exports relatively dearer (in terms of foreign
currencies) and imports relatively cheap in terms of the home currency.
Devaluation involves deliberate action by
monetary authorities to lower the exchange value of their currencies in terms
of other currencies. Devaluation makes exports relatively cheaper and imports
expensive – devaluation discourages imports and corrects BOP deficits.
Appreciation versus Depreciation of Exchange Rates
Appreciation is the gain in the value of a currency due to forces of supply and demand without any intervention by the government and monetary authorities of a country. Depreciation is the loss of value of a currency due to forces of supply and demand without any intervention by the government or any monetary authorities of a country.
Depreciation is the loss of value of a currency due to forces of supply and demand without any intervention by the government or any monetary authorities of a country.
Purchasing Power Parity (PPP) Theory
The PPP is a theory
which states that the exchange rate between one currency and another is in
equilibrium when their domestic purchasing power at that rate of exchange are
equivalent e.g., the rate of exchange 1US$ = 85RTGS would be in equilibrium if
1US$ will buy those same goods in the States as 85 RTGS will buy in Zimbabwe.
If this holds, purchasing power parity exists.
Factors underlying
fluctuations in exchange rates
§ Demand and supply factors.
§ Activities of speculators.
§ The balance between exports and
imports of a country.
§ Capital transactions between that
country and the rest of the world.
§ Exogenous shocks e.g., droughts,
earthquakes, floods, etc, or simply natural disasters.
Author: Tillas Gopoza is an Economist. He writes in
his capacity as the Chief Economist for the Bankers Association of Zimbabwe. He
can be contacted at tillas@baz.org.zw