There are many different currencies in the world. What currency do you use? Is it the euro, pounds, dollars or something else? While there are many different currencies, there are also many different types of exchange rates a country can choose between. In this explanation, we will look at one of these exchange rate types.
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Jetzt kostenlos anmeldenThere are many different currencies in the world. What currency do you use? Is it the euro, pounds, dollars or something else? While there are many different currencies, there are also many different types of exchange rates a country can choose between. In this explanation, we will look at one of these exchange rate types.
There are three different types of exchange rates:
Here we will focus on the floating exchange rate, although we will also discuss the managed exchange rate.
A free-floating exchange rate system is one where the government does not intervene, whatsoever, in determining the exchange rate.
Demand and supply from the free market determine the exchange rate.
A managed exchange rate system is similar to a free-floating exchange rate because demand and supply value the currency and determine its exchange rate. The only difference is that the government or central bank can intervene.
These interventions usually happen in response to volatility and to smooth out fluctuations in the currencies. This system is also called ‘Dirty float’.
To understand the floating exchange rate, you should also keep the following definitions in mind:
The depreciation of a currency is the fall in the value of a currency due to free-market forces.
The appreciation of a currency refers to a rise in the value of a currency due to free-market forces.
Depreciation and appreciation are only used in the context of a floating exchange rate.
Simply put, free-market forces determine the value of a floating exchange rate. However, the main free market determinants are:
These market determinants are influenced by supply and demand.
Let’s look at an example for each main market determinate using the United States Dollar (USD) as our base currency.
Let’s imagine that the USA’s small to medium enterprise exports rise by 60% and that China is its top buyer this year.
How will this impact the USD?
Figure 1 below illustrates this for us.
More US exports will be sold to China. This increase in demand for US exports will also increase the demand for US dollars. This is why the demand curve shifts outwards from D1 to D2. The exchange rate of US dollars to the Chinese Yuan rises, so the US dollar appreciates.
Imagine that Nigeria attracts $40 billion (USD) in foreign direct investment (FDI).
Figure 2 illustrates the impact on the USD.
Remember that for Nigeria, it is an inflow of $40 billion while for the US it is an outflow. Because of this, the supply for US dollars increases, thus the supply curve shifts outward from S1 to S2. This leads to a depreciation of the US dollar.
Let’s imagine that the US is having an election and people believe that due to the uncertainty, the US dollar is going to fall in value.
Figure 3 illustrates the impact on the USD.
Due to this speculation, investors will avoid buying the dollar. This causes the demand for the dollar to fall from D1 to D2. Investors will sell the dollar and this increases the supply of US dollars in the money market, so the supply curve shifts from S1 to S2. Due to the fall in demand and increase in supply, there is a double shift with both curves: the demand curve shifts inwards, whilst the supply curve shifts outwards. This results in a depreciation of the US dollar.
As we know, a floating exchange rate is determined by free-market forces. However, these forces are based on demand and supply which can fluctuate at any moment.
Some fluctuations in the free market that can influence a floating exchange rate are:
From past examples in this article, we know that the US has a floating exchange rate. Some other countries with a floating exchange rate are:
Countries are free to adopt whichever system works better for their macroeconomic policy planning. Sometimes, countries move from one system to the other as they grow or change the course of their economic planning.
Many countries and governments opt for a floating exchange rate for many different reasons. Some of the advantages of that system are:
In a fixed exchange rate system, interest rates are established for keeping the exchange rates fixed rather than due to their impacts on the local economy.
Reduces large currency reserves. Governments and central banks don't need to hold large amounts of currency reserves to buy back or sell their currency. The cost of holding these reserves are very expensive so the government can use this money elsewhere in the economy.
The floating exchange rate system has some disadvantages too. Some of them are:
Volatility. The free market is prone to sharp fluctuations and this also impacts a floating exchange rate. These fluctuations can wipe out the value of a currency in a single day. Because of how volatile it can be, investors might stay clear of these currencies. Deterring investment can severely impact a country's economic growth and development.
Instability. Due to internal and external factors, such as speculation, there is no guarantee that a floating exchange rate will be stable. This instability in a currency can impact both consumer and business confidence which will ultimately lead to lower consumption and investment which will restrict economic growth.
Doesn't correct a current account deficit. One advantage of a floating exchange rate was that it was a partial correction for a currency account deficit. However, this only holds true if the Marshall Lerner condition holds true. If this condition is not met, then a current account deficit will not be corrected automatically.
The Marshall Lerner condition and the J curve
The Marshall Lerner condition states: ‘A depreciation of the exchange rate will eventually lead to an improvement in the current account provided the sum of the price elasticity of demand (PED) for exports and imports > 1’.
Why is this the case?
Remember that there is a link between total revenue and PED. Total revenue increases when prices decrease when the demand curve is elastic. When the demand curve is inelastic, and prices are still increasing, total revenue decreases. You can see this in the table below.
PED | Price | Total revenue |
PED elastic | Increases | Decreases |
PED elastic | Decreases | Increases |
PED inelastic | Increases | Increases |
PED inelastic | Decreases | Decreases |
Table 1. The link between PED and total revenue.
This can be applied to the PED of exports and imports.
Imagine the PED for exports is inelastic. A country wants its exports to be price competitive so it has low prices. From the bottom row of the table, we can see that a decrease in price leads to a decrease in total revenue. Thus, export revenue will fall.
If the PED for imports is inelastic, and import prices are high, a country spends more on imports. For their trading country, their total revenue will increase.
PED(X-M) inelastic will worsen the current account deficit and depreciate a currency.
The J curve also illustrates this point graphically.
Initially, the current account deficit worsens in the short term. This is because Marshall Lerner's condition is not met. But in the long term, the current account starts to improve as the condition holds true and consumers start to realise the gains in the change in the exchange rate.
A floating exchange rate is one where the government doesn't intervene in determining the exchange rate and it is determined by free market forces.
A fixed exchange rate is where the government or the central bank plays a central role in 'fixing' it and 'maintaining it'. A floating exchange rate is where the government doesn't intervene in determining the exchange rate and it is determined by free market forces.
One example of a floating exchange rate is the US dollar.
What are the three different types of exchange rates?
Define a floating exchange rate.
A free floating exchange rate system is one where the government does not intervene, whatsoever, in determining the exchange rate.
Define a managed exchange rate.
A managed exchange rate system is an exchange rate system where demand and supply value the currency and its exchange rate but the government or central bank can intervene.
What is a managed exchange rate also known as?
Dirty float
Define depreciation.
Depreciation of a currency refers to a fall in the value of a currency due to free market forces.
Define appreciation.
Appreciation of a currency refers to a rise in the value of a currency due to free market forces.
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