This lesson introduces floating exchange rates: a system in which the foreign exchange market determines a currency’s value. Understanding floating rates matters because exchange-rate changes affect trade, investment, businesses, and households.
A floating exchange rate is an exchange-rate policy that allows supply and demand in the foreign exchange market to determine the value of a currency. The U.S. dollar is an example, and roughly 40% of the world’s countries use floating rates.
All flashcards
Floating exchange rate
A currency value determined by supply and demand in the foreign-exchange market.
Soft peg
An exchange-rate policy that permits some market movement while using selective central-bank intervention.
Hard peg
An exchange-rate policy in which the central bank seeks to maintain a fixed value.
Foreign-exchange reserves
Foreign currencies held by a central bank for transactions such as supporting its exchange-rate target.
Merged currency
A common currency used by two or more countries.
Quiz questions
What is a typical monetary-policy consequence of maintaining a hard peg?Answer: The central bank has little freedom to set policy independently of the exchange-rate target.
What limits a central bank's ability to strengthen its currency by buying it with foreign-exchange reserves?Answer: The central bank can use this method only while it has foreign reserves available.
What is one difficulty in using Tobin taxes or capital controls to limit rapid international capital flows?Answer: Investors may shift transactions elsewhere, and trade-related flows can be hard to distinguish.
What monetary-policy tradeoff does a country face when it adopts a shared currency?Answer: It removes exchange-rate risk among members but gives up independent national monetary policy.
All else equal, how can a stronger U.S. dollar affect U.S. exporters?Answer: Their goods become more expensive to foreign buyers, which can reduce sales.
Based on Principles of Economics 3e by Steven A. Greenlaw, David Shapiro, Daniel MacDonald (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.