DMPQ- Highlight the major determinants of currency exchange rates.

Exchange rate determination is either as pegged/fixed exchange rates or market-determined exchange rates. Pegged or fixed exchange rates are determined as a direct intervention of the central bank in deciding on the exchange rates. There are certain variants to such interventions like:

Currency Board

The central bank of a country pegs the home currency to a stronger currency on a 1:1 basis or on a different ratio, as pegged exchange rate.

That is, home currency in circulation would depend on the available, inflow of foreign currency. This is also referred to as the currency board’ system, advocated for economies experiencing uncontrollable inflation of very high levels. It is believed to impose strict monetary discipline and takes away monetary independence. Common examples of currency board system are Argentina, Hong Kong, etc.

Crawling/Pegged Exchange Rates

This is similar to fixed exchange rate but with the central bank of that country having the flexibility of letting the exchange rate to float in a small band with a ceiling and a floor’. Examples are China, Russia, etc.

Market-determined exchange rates are as follows:

Full Float

The exchange rate in such economies is market-determined by the forces of demand and supply of foreign currency in the home country with no role of the central bank in exchange rate determination. Most economies such as the US, EU are full float economies.

Managed floating exchange rate

A managed floating exchange rate is a regime that allows an issuing central bank to intervene regularly in FX markets in order to change the direction of the currency’s float and shore up its balance of payments in excessively volatile periods. This regime is also known as a “dirty float”.

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