A multinational company’s access to international capital markets and its freedom to move funds
across national boundaries are subject to a variety of national constraints. These constraints are
frequently imposed to meet international monetary agreements on determining exchange rates.
Constraints may also be imposed to correct the balance-of-payments deficit or to promote
national economic goals.
A successful exchange system is necessary to stabilize the international payment system. To be
successful, an exchange system should meet three conditions:
1Balance-of-payments deficits or surpluses by individual countries should not be too large or
prolonged.
2Such deficits or surpluses should be corrected in ways that do not cause unacceptable infla-
tion or physical restrictions on trade and payments for either individual countries or the
whole world.
3 The maximum sustainable expansion of trade and other international economic activities
should be facilitated.
Theoretically, continuous balance-of-payments deficits and surpluses cannot exist around the
world. Under a system of freely flexible exchange rates, a foreign-exchange market clears itself
in the same way a competitive market for goods does. Just like every commodity price, each
exchange rate moves to a level at which demand and supply are equal. Under a system of fixed
exchange rates, central banks or other designated agencies buy and sell on the open market to
absorb surpluses and to eliminate deficiencies of foreign currencies at the fixed exchange rates.
A foreign-exchange rate is the price of one currency expressed in terms of another currency. A
fixed exchange rate is an exchange rate that does not fluctuate or that changes within a prede-
termined band. The rate at which the currency is fixed or pegged is called the “ par value .” A
floating orflexible exchange rate is an exchange rate that fluctuates according to market forces.
Although governments do not attempt to prevent fundamental changes in the exchange rate
between their own currency and other currency, they typically attempt to maintain orderly
trading conditions in the market. A flexible exchange system has a number of advantages:
1 Countries can maintain independent monetary and fiscal policies.
2Flexible exchange rates permit a smooth adjustment to external shocks.
3 Central banks do not need to maintain large international reserves to defend a fixed exchange
rate.
Howeve r, a flexible exchange system has several disadvantages. First, exchange rates under a pure
version of this system are highly unstable, thereby discouraging the flow of world trade and invest-
ment. Second, flexible exchange rates are inherently inflationary, because they remove the exter-
nal discipline on government economic policy.
A system of fixed exchange rates provides the stability of exchange rates, but it has some
disadvantages:
1 The stability of exchange rates may be too rigid to take care of major upheavals such as wars,
re volutions, and widespread disasters.
2 Central banks need to maintain large international reserves to defend a fixed exchange rate.
3Fixed exchange rates may result in destabilizing speculation that causes the exchange rate
to “overshoot” its natural equilibrium level. Overshoot (beyond fair value) is natural after
devaluation. For example, all three developing-country financial crises since 1980 – the Latin
American crisis of the 1980s, the Mexican peso crisis of 1994, and the Asian crisis of 1997–8
– occurred under fixed exchange rate regimes.
Four concepts – appreciation, depreciation, revaluation (upvaluation), and devaluation – are all
related to changing the value of a currency. An appreciationis a rise in the value of a currency
against other currencies under a floating-rate system. A depreciationis a decrease in the value
of a currency against other currencies under a floating-rate system. Under a system of floating
rates, a country’s exchange rate will appreciate if it raises interest rates to attract capital. Simi-
larly, its exchange rate will “depreciate” if it reduces interest rates.
A re valuation is an official increase in the value of a currency by the government of that cur-
rency under a fixed-rate system. A devaluation is an official reduction in the par value of a cur-
rency by the government of that currency under a fixed-rate system. Under a system of fixed
rates, a country may “devalue” its exchange rate by setting a lower intervention price at which it
will intervene in the foreign-exchange market. It may “revalue” or “upvalue” its exchange rate by
setting a higher intervention price.
across national boundaries are subject to a variety of national constraints. These constraints are
frequently imposed to meet international monetary agreements on determining exchange rates.
Constraints may also be imposed to correct the balance-of-payments deficit or to promote
national economic goals.
A successful exchange system is necessary to stabilize the international payment system. To be
successful, an exchange system should meet three conditions:
1Balance-of-payments deficits or surpluses by individual countries should not be too large or
prolonged.
2Such deficits or surpluses should be corrected in ways that do not cause unacceptable infla-
tion or physical restrictions on trade and payments for either individual countries or the
whole world.
3 The maximum sustainable expansion of trade and other international economic activities
should be facilitated.
Theoretically, continuous balance-of-payments deficits and surpluses cannot exist around the
world. Under a system of freely flexible exchange rates, a foreign-exchange market clears itself
in the same way a competitive market for goods does. Just like every commodity price, each
exchange rate moves to a level at which demand and supply are equal. Under a system of fixed
exchange rates, central banks or other designated agencies buy and sell on the open market to
absorb surpluses and to eliminate deficiencies of foreign currencies at the fixed exchange rates.
A foreign-exchange rate is the price of one currency expressed in terms of another currency. A
fixed exchange rate is an exchange rate that does not fluctuate or that changes within a prede-
termined band. The rate at which the currency is fixed or pegged is called the “ par value .” A
floating orflexible exchange rate is an exchange rate that fluctuates according to market forces.
Although governments do not attempt to prevent fundamental changes in the exchange rate
between their own currency and other currency, they typically attempt to maintain orderly
trading conditions in the market. A flexible exchange system has a number of advantages:
1 Countries can maintain independent monetary and fiscal policies.
2Flexible exchange rates permit a smooth adjustment to external shocks.
3 Central banks do not need to maintain large international reserves to defend a fixed exchange
rate.
Howeve r, a flexible exchange system has several disadvantages. First, exchange rates under a pure
version of this system are highly unstable, thereby discouraging the flow of world trade and invest-
ment. Second, flexible exchange rates are inherently inflationary, because they remove the exter-
nal discipline on government economic policy.
A system of fixed exchange rates provides the stability of exchange rates, but it has some
disadvantages:
1 The stability of exchange rates may be too rigid to take care of major upheavals such as wars,
re volutions, and widespread disasters.
2 Central banks need to maintain large international reserves to defend a fixed exchange rate.
3Fixed exchange rates may result in destabilizing speculation that causes the exchange rate
to “overshoot” its natural equilibrium level. Overshoot (beyond fair value) is natural after
devaluation. For example, all three developing-country financial crises since 1980 – the Latin
American crisis of the 1980s, the Mexican peso crisis of 1994, and the Asian crisis of 1997–8
– occurred under fixed exchange rate regimes.
Four concepts – appreciation, depreciation, revaluation (upvaluation), and devaluation – are all
related to changing the value of a currency. An appreciationis a rise in the value of a currency
against other currencies under a floating-rate system. A depreciationis a decrease in the value
of a currency against other currencies under a floating-rate system. Under a system of floating
rates, a country’s exchange rate will appreciate if it raises interest rates to attract capital. Simi-
larly, its exchange rate will “depreciate” if it reduces interest rates.
A re valuation is an official increase in the value of a currency by the government of that cur-
rency under a fixed-rate system. A devaluation is an official reduction in the par value of a cur-
rency by the government of that currency under a fixed-rate system. Under a system of fixed
rates, a country may “devalue” its exchange rate by setting a lower intervention price at which it
will intervene in the foreign-exchange market. It may “revalue” or “upvalue” its exchange rate by
setting a higher intervention price.
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