Problems With Foreign Exchange Rates
In a floating exchange rate system, the exchange rate is determined as the rate that equalizes private market demand for a currency with private market supply. The central has no necessary role to play in the determination of a pure floating exchange rate. |
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At times central banks need, or are forced by external groups, to take actions (i.e. interfere or get involved) to either raise or lower the exchange rate in a floating exchange system. When central banks arbitrate on a semi-regular basis the system is sometimes referred to as a "dirty float." There are numerous reasons associated with such intercessions.
Primarily, the central banks interfere to secure variations in the exchange rate. International trade and investment decisions are greatly intricate if the exchange rate value is altering speedily. If the exchange rate varies rapidly, traders and investors will become more indecisive about the profitability of trades and investments and this may result in reduction of their international activities.
Hence, international traders and investors choose more unwavering exchange rates and frequently pressure governments and central banks to interfere in the foreign exchange market.
The second reason central banks interfere is to repeal the growth in the country's trade shortage. Trade shortages (or current account deficits) can increase quickly if a country's exchange rate mounts considerably. A higher currency value will make foreign goods and services (G&S) fairly cheaper, inspiring imports, whilst domestic goods will appear moderately more costly to foreigners, hence plummeting exports. This means a rising currency value can lead to a rising trade deficit. If that trade deficit is viewed as a problem for the economy, the central bank may be pressured to intervene to reduce the value of the currency in the FOREX market and thereby reverse the rising trade deficit.
There are two ways central banks can utilize to influence the exchange rate. The direct method is to interfere openly in the foreign exchange market by buying or selling currency. And the indirect method is to transform the domestic money supply.
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