Foreign Exchange Market and Exchange Rate Dynamics

The Foreign Exchange Market and Exchange Rate

Currency Devaluation

To regain economic competitiveness, countries often devalue their local currency. This action improves the balance of payments because national products and services become cheaper, attracting foreign customers. Conversely, foreign products and services become more expensive, encouraging domestic consumption.

Exchange Rate Determination

Currently, exchange rates for most currencies are not officially fixed but fluctuate freely in markets. However, many developing countries maintain government controls on their currency's price. Central banks often adapt the exchange rate based on supply and demand. Developed countries, including China, do not officially set exchange rates but often engage in practices like a "dirty float." This involves allowing currencies to fluctuate but intervening to ensure favorable exchange rates.

China's Exchange Rate Management

China, for example, aims to keep the yuan low to encourage exports. To achieve this, the government sells its currency and buys foreign currencies, increasing the supply of yuan and lowering its price. China invests heavily in U.S. Treasury bills to manage the yuan's rate against the dollar.

Drawbacks of Devaluation

• Imports Inflation: Devaluation makes imports more expensive. While some imports can be substituted with domestic production, others, like oil, cannot. This leads to overall price increases as imported inputs become more costly.