Inflation Rates The price of one currency in terms of another is called the exchange rate. The exchange rate affects the economy in our daily lives because it affects the price of domestically produced goods sold abroad and the cost of foreign goods bought domestically. Mexicans use pesos, French use francs, Austrians use schillings, and this use of different monies by different countries results in the need to exchange one money for another to facilitate trade between countries(Husted 315). Without the exchange rate it would make it impossible to purchase goods in other countries that have a different currency. Day-to-day movements in exchange rates are closely related to peoples expectations. The role of monetary policy would be to manage the exchange rate.
A monetary expansion would tend to lower interest rates, thus lead to short-term funds flowing into foreign currencies, and so depreciate the domestic currency(Corden 21). Throughout the history of the economy, the exchange rate has not always been controlled under the same monetary system. Foreign exchange is usually traded as bank accounts denominated in different currencies. Most of the trade takes place between the major banks and between banks and their corporate customers. Modern communications make it a truly global market. The rates vary by minute.
Exchange rates changes are largely unexpected and so there is an important element of risk in multinational transactions that domestic transactions lack(Husted 320). The closing rates in each financial center are reported regularly in the media. The closing rates of the previous day are listed in the morning newspaper for leisurely reading. There are two main types of foreign exchange systems: 1) fixed exchange rate, and 2) floating exchange rate. A fixed exchange rate system is where governments can set a certain fixed rate at which their currencies will exchange for each other and then commit themselves to maintaining this rate.
Countries use an agreed-upon currency worth a specific measure standard. On the other hand, the unregulated forces of supply and demand determine the floating exchange rate system. During this, there is a trade-off between the rate of inflation and the current account(Corden 86). If a country imports large quantities or goods, the demand will push up the exports imports large quantities of good, the demand will push up the exchange rate for that country, making the imported goods more expensive to buyers in that country. As the goods become more expensive, demand drops, and that countrys money becomes cheaper in relation to other countries money(Gwinn 627).
From 1870 to 1914, the exchange rate was determined by the Gold Standard. This system was a fixed exchange rate, and the way it worked was by pricing every currency in terms of gold. So in general terms, if X amount of one currency was equal to one ounce of gold, and Y amount of currency was also equal to one ounce of gold, then X and Y can also be exchanged. But this system had many flaws that led to a new system after all those years. The main problem with the gold standard arose due to the fact that the money supplied depended a great deal on the amount of gold held in banks, but the countries had little control over the money supply. If the demand for a currency exceeded the actual supply, banks were forced to ship gold to satisfy the individual country’s requirements for the scarce currency.
A flow of gold into a country obviously increased the money supply, which in turn raised prices and made its goods more expensive. This, in turn, reduced foreign demand for its currency. Then an example of how this relates to exchange rates is that if the total demand for a certain currency is decreased, the value of the currency also decrease. So more of it has to be exchanged for another currency to be equal in value. So because of this problem, the gold standard was replaced by a new monetary system.
This new system was established near the end of World War II, and it was called the Bretton Woods system. The experts who had negotiated the Bretton Woods Agreement, and the Governments that had endorsed it, had been inspired by a desire to learn from lessons of inter-war experience and to prevent its recurrence after the removal of war-time exchange control(Einzig 12). The system that had promised to prolong war-time stability of exchange rates was welcomed with open arms by most people(Einzig 13). This system was also like a fixed exchange rate system because it established rules that stated that each country agreed not to alter the exchange value of their currencies beyond certain limits without prior consent. As a result, of the Bretton Woods system did not turn out to be what was planned; instead of promoting a growth it had a negative affect on international trade. Governments both will not and cannot stick to pegged or fixed rates.
First, maintaining targeted or fixed rates requires a consistent and fairly uniform monetary policy among nations. There are many reasons that national governments will not consent to this, the most important reason is that different countries want different things, different economies have different needs and different governments have different policies. There are other problems with fixed rates. Even if the system could be maintained, the economies in the rest of the world probably are not integrated enough to deal with a fixed rates system and correct imbalances of trade. Money is free to flow from county to county, but labor is not and neither are many businesses. So in the 1970s the Bretton Woods system and the fixed exchange rate system gave way to a floating rate system, where, as mentioned before, the rates are largely determined by supply and demand in international currency markets.
It was in 1971 that the United States replace the gold standard completely because the United States refused to convert dollars, held by foreign central banks, into gold anymore and the U.S. tried maintaining the dollar at a fixed exchange rate with other currencies instead of gold. But this still was not a good system. Then by 1973 the Bretton Woods system was no longer in effect either, and the change to the floating exchange rate system was complete. Since March 1973, there has been five main currencies, they make up a managed floating non-system.
Each country has been completely free to conduct its monetary policy as it wished, and flexib …