Evaluating exchange rate policy

Overview

Case for a policy of maintaining a competitive exchange rate, case for a policy of maintaining a strong exchange rate and costs of a policy of maintaining a strong exchange rate.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   On what grounds would a country choose a fixed rate over a floating one, and what does it give up by doing so?

   Model answer

   A fixed rate gives certainty to traders and investors and imposes discipline on domestic inflation, since the country cannot let prices drift without losing competitiveness. What it gives up is monetary independence: interest rates must be set to defend the rate rather than to suit domestic conditions, and reserves must be held to intervene. A floating rate frees policy for domestic use but leaves firms exposed to swings in the rate.

2. 2

   Analyse the case for a policy of maintaining a competitive exchange rate.

   Model answer

   A currency held at a level that keeps domestic producers cheap relative to foreign rivals supports export volumes and displaces imports, which raises output and employment in traded sectors and improves the current account. It gives exporters the certainty of a favourable environment in which to invest in capacity, and it can be a deliberate strategy for building an industrial base. The gains apply to all traded sectors at once without the administrative cost of selecting industries.

3. 3

   Analyse the costs of a policy of maintaining a deliberately weak exchange rate.

   Model answer

   Imports of food, fuel, components and consumer goods all cost more in domestic currency, which raises the cost of living, cuts real incomes and raises inflation. Keeping the rate down requires the central bank to buy foreign currency continuously, expanding the domestic money supply and adding further to inflation unless it is sterilised, and accumulating large low-yielding reserves that represent a real cost. Domestic producers are shielded from competitive pressure, so productivity improvement slows. Trading partners may retaliate. And the inflation the policy generates gradually erodes the competitiveness it was designed to deliver.

4. 4

   Analyse the case for a policy of maintaining a strong exchange rate.

   Model answer

   A strong currency lowers the domestic price of imported food, fuel, components and finished goods, which reduces inflation and raises real incomes directly. It reduces the cost of imported capital equipment, supporting investment and productivity growth. It imposes discipline on domestic producers, who must control costs and improve quality because they cannot rely on a cheap currency, which can raise long-run competitiveness. It lowers the domestic cost of servicing foreign currency debt, and it improves the terms of trade, so each unit exported buys more imports.

5. 5

   Analyse the costs of a policy of maintaining a strong exchange rate.

   Model answer

   Exports become dearer in foreign currency and imports cheaper at home, so traded sectors lose sales, and where the currency is held above its sustainable level the losses fall on manufacturing and other export industries, with concentrated regional unemployment. The current account deteriorates. Holding the rate up requires selling foreign currency reserves or maintaining high interest rates, and high rates depress domestic investment and consumption. Firms that close under an overvalued currency do not necessarily reopen when it falls, so the damage can be permanent.

6. 6

   Explain the conflict between using the exchange rate to support employment and using it to control inflation.

   Model answer

   A lower exchange rate raises demand for domestic output by making exports cheaper and imports dearer, supporting output and employment in traded sectors, but it also raises the domestic price of everything imported, which raises inflation. A higher exchange rate does the reverse, restraining inflation while depressing traded-sector employment. Since the two objectives require movements in opposite directions, the exchange rate cannot serve both simultaneously and the authorities must decide which problem is more pressing.

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