Key Concepts and Summary

Key Concepts and Summary

In a floating exchange rate policy, a country’s exchange rate is determined in the foreign exchange market. In a soft peg exchange rate policy, a country’s exchange rate is usually determined in the foreign exchange market, but the government sometimes intervenes to strengthen or weaken the exchange rate. In a hard peg exchange rate policy, the government chooses an exchange rate. A central bank can intervene in exchange markets in two ways. It can raise or lower interest rates to make the currency stronger or weaker. Or it can directly purchase or sell its currency in foreign exchange markets. All exchange rates policies face tradeoffs. A hard peg exchange rate policy will reduce exchange rate fluctuations, but means that a country must focus its monetary policy on the exchange rate, not on fighting recession or controlling inflation. When a nation merges its currency with another nation, it gives up on nationally oriented monetary policy altogether.

A soft peg exchange rate may create additional volatility as exchange rate markets try to anticipate when and how the government will intervene. A flexible exchange rate policy allows monetary policy to focus on inflation and unemployment, and allows the exchange rate to change with inflation and rates of return, but also raises a risk that exchange rates may sometimes make large and abrupt movements. The spectrum of exchange rate policies includes: (a) a floating exchange rate, (b) a pegged exchange rate, soft or hard, and (c) a merged currency. Monetary policy can focus on a variety of goals: (a) inflation; (b) inflation or unemployment, depending on which is the most dangerous obstacle; and (c) a long-term rule based policy designed to keep the money supply stable and predictable.

Glossary

floating exchange rate

a country lets the value of its currency be determined in the exchange rate market

hard peg

an exchange rate policy in which the central bank sets a fixed and unchanging value for the exchange rate

international capital flows

flow of financial capital across national boundaries either as portfolio investment or direct investment

merged currency

when a nation chooses to use the currency of another nation

soft peg

an exchange rate policy in which the government usually allows the exchange rate to be set by the market, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene

Tobin taxes

see international capital flows