More than a few nations have been compelled over the years to fix one or more of their exchange rates. A country might fix exchange rates at relatively low levels to increase exports and decrease imports, which generates a more "favorable" balance of trade. Alternatively one country might fix their exchange rate relative to that in another (often larger) country as a means of stabilizing their domestic economy.

The Foreign Exchange Market for Csonds

The Foreign Exchange Market

The demand for csonds is given by the negatively-sloped demand curve, labeled D. The demand of csonds is then represented by the positively-sloped supply curve, labeled S. The intersection of the demand and supply curves is the equilibrium exchange rate for csonds, in terms of queolds. The exchange rate is 5 queolds per csond, with 100 csonds exchanged.

If the exchange rate is flexible, then it adjusts to eliminate any imbalance. A shortage -- quantity demanded exceeds quantity supplied -- induces an increase in the exchange rate. A surplus -- quantity supplied exceeds quantity demanded -- induces a decrease in the exchange rate.

Let's see what might happen if the Csondan government decides to fix the exchange rate at a level that is higher or lower than 5 queolds per csond.

Fixed Higher

What are the likely consequences of this action?

• First, on the international trade side, a higher exchange rate makes the Csondan currency more expensive, which is bound to discourage the purchase of Csondan exports. On the other side of the net exports equation, more expensive domestic currency makes foreign currency relatively cheaper, which is bound to encourage the purchase of foreign imports by the Csondan citizens.


• Second, in terms of the balance of payments, the surplus in the foreign exchange market leads to a balance of payments deficit. As the Csondan central bank buys enough csonds to keep the rate fixed above equilibrium, there is an outflow of payments to other countries, which creates the balance of payments deficit.

Fixed Lower

What are the likely consequences of this action?

• First, on the international trade side, a lower exchange rate makes the Csondan currency less expensive, which is likely to encourage the purchase of Csondan exports. On the other side of the net exports equation, less expensive domestic currency makes foreign currency relatively more expensive, which is bound to discourage the purchase of foreign imports by the Csondan citizens.


• Second, in terms of the balance of payments, the shortage in the foreign exchange market leads to a balance of payments surplus. As the Csondan central bank sells enough csonds to keep the rate fixed below equilibrium, there is an inflow of payments from other countries, which creates the balance of payments surplus.

Appreciation and Depreciation

• Appreciation: A currency is said to appreciate in value if its exchange rate increases, such as an increase in the exchange rate of csonds from 5 queolds per csond to 6 queolds per csond. Currency appreciation makes exports from the country relatively more expensive resulting in fewer exports and usually more imports.


• Depreciation: Alternatively, a currency is said to depreciate in value if its exchange rate decreases, such as a decrease in the exchange rate of csonds from 5 queolds per csond to 4 queolds per csond. Currency depreciation makes exports from the country relatively less expensive resulting in more exports and usually fewer imports.

However, because most countries prefer more exports to fewer exports, depreciation policies of one country are not viewed favorably by its trading partner. The trading partner might even counter with its own currency deprecation policies, policies that might cancel or even surpass that of the first country.

Let the conflict begin!

These countries, and others drawn into the fray, are likely to run rampant with currency depreciation policies, especially domestic money supply increases. Each country trying to out "depreciate" the others. Unfortunately such policies are bound to cause domestic inflation and result in other problems in their domestic economies.

Why Fix?

• One, countries often fix their exchange rate below the equilibrium level to promote exports, limit imports, and generate a balance of payments surplus. These results are generally deemed "good" for a nation, promoting growth and prosperity, at least in the short run. However, a low exchange rate for one nation is necessarily a high exchange rate for another. In the long run, other nations are likely to pursue the same strategy, seeking to fix their exchange rates below equilibrium, too. Unfortunately, international trade and the foreign exchange markets are essentially a zero-sum game, all nations cannot undertake this strategy at the same time.


• Two, a fixed exchange rate generally promotes stability in the global economy. Buyers and sellers, importers and exporters, have a degree of certainty which helps them plan for future trades and makes them more willing to enter into long-term contracts. Market conditions might cause an unrestrained equilibrium exchanged rate to rise above the selected fixed exchange rate at some times and fall below it at other times.


• Three, fixing the exchange rate between a domestic currency and that of another nation is effectively the same as having a single currency. In large countries like the United States, the currency used by each state has a fixed exchange rate for that used by every other state (which wasn't necessarily the case in the colonial period). Often a smaller nation fixes its exchange rate to the currency of a larger, dominant nation as a means of integrating the two economies.


• Four, one country might be "encouraged" (or forced) to fix exchange rates for their domestic currency through pressure from other countries or international government agencies (such as the International Monetary Fund) to achieve global goals. Countries, if left to their own accords, are prone to fixed exchange rates relatively low, which encourages exports, discourages imports, adversely affects other countries, and creates domestic inflation. To address the problems of low exchange rates, pressure might be imposed on a country to fix their exchange rates at higher levels.

Two Other Exchange Rate Policies

• Flexible Exchange Rate: A flexible exchange rate, also termed floating exchange rate, is an exchange rate determined through the unrestricted interaction of supply and demand in the foreign exchange market. A flexible exchange rate means that a country is NOT trying to manipulate currency prices to achieve some change in the exports or imports. This policy is based on the presumption that the free interplay of market forces is most likely to generate a desireable pattern of international trade.


• Managed Flexible Exchange Rate: A managed flexible exchange rate, what is also termed a managed float, is an exchange rate that is generally allowed to adjust due to the interaction of supply and demand in the foreign exchange market, but with occasional intervention by government. Most nations of the world currently use a managed flexible exchange rate policy. With this alternative an exchange rate is free to rise and fall, but it is subject to government control if it moves too high or too low. With managed float, the government steps into the foreign exchange market and buys or sells whatever currency is necessary keep the exchange rate within desired limits.