EXCHANGE RATE DETERMINATION

Exchange Rate Determination

Exchange Rate Determination

The exchange rate represents the price at which one currency can be bought by another. Currency trading takes place on auction markets, known as foreign exchange markets, where annual turnover now exceeds global domestic product (GDP) by a factor in excess of forty (Strange, 2007). The exchange-rate regime refers to the public management of exchange rate relations, and thus shapes the context for trading on the foreign exchange market. The prevailing exchange-rate regime is determined by the decisions of governments, usually acting collectively under the auspices of an international agreement. On certain occasions, however, economically powerful countries have been able to reconfigure the exchange-rate regime while acting unilaterally (Mosley, 2008).

The academic literature tends to focus on the difference between two types of exchange-rate regime: fixed versus floating. A fixed regime locks in the relative value of domestic currencies, hence determining the price at which they are exchanged. The classical gold standard, in operation in its purest form between 1870 and 1914, provided the basis for one fixed exchange-rate regime. Each currency had a set price in relation to gold and, because gold acted as a common denominator, each currency also had a set price in relation to one another (Eichengreen, 2006). The postwar international economic order, which was negotiated at Bretton Woods in 1944, was also underpinned by a fixed exchange-rate regime. This time, however, the relationship between the U.S. dollar and gold, rather than gold alone, acted as the lynchpin of the system.

By 1971, inflationary pressures in the United States undermined the effective value of the dollar, prompting investors to attempt to convert dollars into gold to protect the value of their assets. U.S. reserves, depleted by the country's first trade deficit of the twentieth century, plus the financial cost of the Vietnam War, were insufficient to meet the demand for dollar convertibility (Kenen, 2007).

As a response, U.S. President Richard Nixon reneged on his country's Bretton Woods' commitments by suspending the convertibility of the dollar into gold. With the central coordinating mechanism of the fixed exchange-rate regime thus disabled, the international currency system increasingly took on the characteristics of a floating regime (Strange, 2007). The international support structure for fixed exchange rates was formally dismantled in incremental stages throughout the 1970s, making the public management of exchange rate relations once again a matter of national policy (Mosley, 2008).

Over the following decade, an increasing number of governments decided to liberalize their exchange rates, thus allowing currencies to float freely.

The economic case for floating exchange rates is that they facilitate more flexible management of the international economy. A fixed exchange-rate regime provides asymmetric incentives for governments to negotiate realignments in their currencies' official value. If underlying economic conditions suggest that a currency is pegged at too high a price, it is in the economic interests of both the government in question and the system as a whole for negotiations to be initiated to lead to the eventual devaluation of the currency (Eichengreen, ...