Distinguish between a fixed and a managed floating exchange rate system
Floating exchange rates
When a country uses a floating exchange rate system:
* The value of the currency is determined purely by demand and supply of the currency
* Trade flows and capital flows affect the exchange rate under a floating system
* There is no target for the exchange rate and no intervention in the market by the central bank
Sterling has floated since the UK suspended membership of the ERM in September 1992. The Bank of England has not intervened to influence the pound’s
value since it became independent.
Managed floating exchange rate
When a country uses a managed floating exchange rate system
* The value of a currency from day to day is determined by market demand for and supply of the currency
* Some currency market intervention might be considered as part of demand management (e.g. a desire for a slightly lower currency to boost export demand)
* Intervention can either be explicit i.e. a central bank buys foreign currency when it wants the domestic currency to depreciate
* Intervention might come from changes in policy interest rates so as to affect the net flows of short term banking money (so-called “hot money”)
* Verbal intervention is when a central bank tries to send a signal to the currency markets that it wishes the currency to move in a certain direction and that it stands by ready to engage in official market intervention if this does not happen
In 2012 a growing number of countries are moving towards managed or “dirty” floating systems. Brazil, Japan, Switzerland and Norway have all intervened in the currency markets in recent months.
Brazil in particular has claimed that developed nations are seeking to undervalue their currencies to create a competitive advantage in the world economy and kick-start their economies. They have introduced extra taxes on the interest paid on foreign deposits in their banking system.
Competitive devaluations occur when a country deliberately intervenes in foreign exchange markets to drive down the value of their currency to provide a competitive boost to demand and jobs in their export industries. They may also try to do this when faced with the threats of a deflationary recession. Another reason is to entice extra foreign investment into a currency
For nations with persistent trade deficits and rising unemployment a competitive devaluation of the exchange rate can become an attractive option - but there are risks. One is that devaluing an exchange rate can be seen by other countries as a form of trade (or crisis) protectionism that invites some form of retaliatory action. Cutting the exchange rate makes it harder for other countries to export their goods and services hitting their circular flow.