Throughout this course we have examined how equilibrium is determined in various markets. We began with the product market, looking at the supply and demand for a good. When supply equaled demand, the market price was decided. As we progressed, we saw how the equilibrium of the supply of labor and labor demand set the wage rate and how equilibrium in the market for loanable funds (the capital market) determined the rate of interest. Next we examined macroeconomic markets where the interaction of aggregate demand and aggregate supply changed macroeconomic prices (inflation) and output (GDP). Using the same basic analysis of supply and demand, we will now see how exchange rates are determined.
Exchange rates give us the price of one currency in relation to another. As with any good, the relative price of two currencies is determined by the supply and demand of the currencies in exchange rate markets. We can use basic fundamentals to explain how a domestic currency's price changes in relation to another. For a floating currency, its price in relation to another currency is determined by conditions of supply and demand for the currency.
Before we begin with our analysis of floating exchange rates, consider two other ways in which a currency's value can be determined.
Fixed: a currency may be fixed at a value that will not change in relation to other currencies throughout the world.
Pegged: a currency's value may change, but only in relation to that of another currency. Pegged currencies are favored by smaller, developing economies that desire to promote currency stability in order to facilitate international trade. For example, Korea may peg its won to the Japanese yen. Until recently, Mexico pegged the peso to the dollar at approximately 3.5 pesos to the dollar. This implied that as the dollar's value changed in relation to the yen or mark, the peso changed by the same magnitude as the dollar.
In some cases currencies may be grouped together, as in the European exchange-rate mechanism (ERM), for example. Many European currencies such as the French franc and the Swedish krona are pegged to the German mark. In a system known as the "snake", these currencies do not have to move in strict unison with the mark against other floating currencies. The ERM sets a fixed value of participants' currencies against the mark with allowable upper and lower bounds. Member currencies can fluctuate in relation to the mark until the boundary limit is reached on either the high or low end. This creates a system of currency stability, but allows member countries some discretion in domestic economic policies. To maintain a currency at a fixed level often requires the focus of monetary policy to be exchange rate preservation, with less concern for domestic economic conditions. Over time, European countries hope to establish the European Currency Unit (ECU) as a common currency for the continent.
