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Exchange Rate Systems and Currency Crisis


Financial crisis occurs when the foreign value of a domestic currency unit falls. This thus results to the rise of the liabilities in the balance sheets of exposed economic units. It also afflicts the balance sheet of exposed economic units (Shiller, 2008). Banks get affected either directly or indirectly through their clients’ exposure. Currency crisis may indicate a dramatic drop in the exchange rate and it usually comes in the form of a breakdown of a unilaterally pegged exchange rate arrangement and also as an outcome of the balance of payment.

1. Under a fixed exchange-rate system, what automatic adjustments promote payments equilibrium?

In a fixed exchange rate system, the exchange is not supposed to vary. Therefore, surplus and deficit elimination can be eliminated through government controls on payments and trades, and also by price change. In order to achieve this, the deficit nation is supposed to deflate the economy in order to encourage exports ( Mankiw, 2003). On the other hand a country experiencing surplus is supposed to stimulate its economy in order to discourage exports and at the same time encourage imports. Payment equilibrium can also be achieved through direct government restrictions on the importation of services and goods and loans and investments from foreign countries.

2. What is meant by the quantity theory of money?

Quantity theory of money implies that value is determined by the relationship between supply and demand. This theory states that there is an association between the products sold and the money in the economy (Barro, 2008). Therefore, if the quantity of the money in the economy rises, the prices of products also rise thus resulting to inflation. This results to the buyers paying very high prices for the good and services they buy. Money is just like any other commodity and thus if its supply increase its value decreases. Therefore high supply of money in the economy results to price increase or inflation in order to cover up for the decreased value of the money.

3. When analyzing the income-adjustment mechanism, one must account for the foreign repercussion effect. Explain.

Income adjusted mechanism has a foreign effect. It results to increase income for the surplus nation and at the same time it results to decrease in income of a deficit country. This is because imports of the surplus nation will result to decrease in income because they will substitute the home produced goods. This finally will result to reduced imports. On the other hand the deflated nation will experience a rise in its exports thus resulting to increase in income.

4. How does the J-curve effect relate to the time path of currency depreciation?

The J-curve effect explains the time lag with which a currency depreciation or devaluation results to an improvement in the trade balance. The theoretical basis of the j-curve effect is the elasticity’s approach to the balance of payment. This theory states that a currency depreciation or devaluation is anticipated to improve the trade balance by changing the relative prices of foreign and domestic goods (Carbaugh, 2008). When foreign good are made expensive in the home country and the home country goods are made cheaper in foreign countries, demand for imports will reduce and foreigners will buy more of the home country’s export.

5. How can currency depreciation-induced changes in household money balances promote payments equilibrium?

In most developing countries, currency depreciation is used to cure balance of payment equilibrium after some time. Currency depreciation is as a result of economic development. Therefore if no democratic means available to achieve economic development, inflation can help by permitting capital formation while depreciation can restore balance of payment equilibrium (Davies, 2010).

6. What factors underlie a nation’s decision to adopt floating exchange rates or fixed exchange rates?

Both floating and fixed exchange rate systems have advantages and disadvantages, therefore, no country can permit continuous floating exchange rate because it is not health for the economy (Madura, 2008). On the other hand, no country can allow fixed exchange rate particularly in globalization era. Therefore, a country tries to adopt a system that combines the advantages of the two systems. The extent to which the exchange rate of a country should be floating or fixed cannot be generalized. Thus depending on the needs of a countries economy and other factors, a country can come up with its own exchange rate system.

7. What factors contribute to currency crises?

One of the factors that result to currency crisis is inconsistent government policies which may result to speculative attack to on a fixed exchange rate. Excessive domestic credit creation causes residents to exchange unwanted domestic currency with foreign currency therefore reducing the government stock of international reserves (Haner, 2008). Erosion of the stock reserves causes problems because to maintain the fixed price of foreign exchange , the government must have enough reserves to sell every time the price of foreign exchange is about to rise.

8. Present the case for and the case against a system of floating exchange rates.

Floating exchange rate system is advantageous because the value of a currency will adjust to show the changing market condition (Wright, 2000). For example if UK inflation increases more than for its trading partners this would result to its products becoming expensive abroad. This would result to fall in demand for UK goods and services and also the demand for the pound. This in turn reduces the value of the currency thus making the exports relatively cheaper. On the other hand, floating exchange rate is disadvantageous because the value of the currency change regularly therefore making it difficult for firms to make plans. For example, UK buyers may not know what they will have to pay to import foreign products.


With an eye to international payments, every country has to come up with a payment system. Various degrees of flexibility of the rate of exchange are possible and it depends on the objectives of a country’s economic policy and on its economic environment which system is preferred.

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