Exchange Rate Policy

Exchange rate policy involves choosing an exchange rate system and determining the particular rate at which foreign exchange transactions will take place. A country's exchange rate policy affects the overall level of domestic prices and its relative price structure in domestic currency terms between goods which are traded internationally (tradables) and goods which are produced for the domestic market (non-tradables or home goods).

A country's economic structure and its institutional characteristics are important considerations in determining exchange rate policy. The following characteristics are usually taken into account:

• reliance on primary commodity production and exports (minerals and agricultural crops);

• dependence on essential imports (capital equipment); use of direct investment and official and private lending;

• development of financial markets, availability of experienced personnel, foreign exchange dealers in particular.

Countries have quite a number of options for exchange rate policy:

a. Peg to a single currency.

By pegging the value of a currency to that of a single currency the country facilitates its trade with the country whose currency is used as the peg. Besides, capital flows related to investment may be positively affected by the stability of the exchange rate. Moreover, pegging to a stable currency, like the US dollar, enhances the confidence in the pegging country's currency.

b. Peg to a basket of currencies.

An alternative approach is to peg the currency to a weighted average of several currency values or a basket of currencies. It helps to avoid large swings in its exchange rate with respect to several trading partners’ currencies and enables countries to avoid some import price fluctuations. There are several disadvantages, however, of a basket peg. They are connected with technical difficulties of implementing a peg which would in general change on a daily basis vis-a-vis all of the industrial countries. The pegging country may lose attractiveness to foreign investors because there might be more uncertainty about the future value of the country's currency, reflecting the possibility that a basket peg was more open to manipulation, particularly if details of the composition of the basket were not publicized.

c. Independent floating.

Independent floating means that an exchange rate of any currency is free to float to any level which supply and demand may determine.

Independent floating potentially provides a mechanism for an efficient foreign exchange market.

Most industrial countries and some developing countries have adopted floating or flexible exchange rate systems, because countries have found it expedient for both economic and political reasons to adopt a more flexible system.

Based on: Macroeconomic Adjustment: Policy Instruments and Issues IMF Institute, 1992

Words you may need:

Англійський варіант	Російський варіант	Український варіант
peg	привязка	прив'язка
basket of currencies	корзина валют	кошик валют
alternative approach	альтернативный подход	альтернативний підхід
weighted average	взвешенное среднее значение	зважене середнє значення
swing	колебание	коливання
vis-a-vis	по отношению к	стосовно
independent floating	свободный плавающий курс	вільний змінний курс
expedient	целесообразный	доцільний

Ex. 15.

a) Read the text that follows and find the parts explaining: the aim of reforms of the banking systems in the countries mentioned in the article; the causes of bank insolvencies.

b) Reread the article again and sum up the conclusions of the meeting described in it.