The Brazilian real-The crawling peg was replaced by a floating exchange rate in 1990.
The Hong Kong dollar-It is on a currency board.
The Indonesian rupiah-The managed float was replaced by a floating exchange rate in 1997.
The Malaysian ringitt-The currency peg to a currency basket was replaced by a fixed exchange rate in 1998.
The Phillipine peso-It is on a floating exchange rate.
The Singapore dollar-The currency peg to a currency basket was replaced by a fixed exchange rate in 1985.
The Thai baht-It is on a managed float.
Theory Supply and Demand:
This theory states that the exchange rate is the intersection of the supply of domestic currency (shown as the supply curve) and its demand (shown as the demand curve). The supply of domestic currency is determined by imports and the demand is determined by exports.
1. Monetary Theory:
This theory links money supply and prices to the exchange rate. An increase in money supply leads to an increase in prices (inflation). According to the monetary theory, the exchange rate is the ratio of prices in two countries, so an increase in price causes the exchange rate to be reset. Consider two countries A and
- When the money supply in each country rises, the prices in each country rise. If the growth of money supply in A is greater than the growth of money supply in B, then A experiences a higher inflation rate than B.
According to the Purchasing Power Parity theory, the exchange rate is nothing but the ratio of prices between two countries. Since A has had a relatively greater rise in prices, A‘s currency depreciates, will fall, and a new exchange rate will get established.
The monetary theory states that there is a direct connection between relative changes in money supply in two countries and the exchange rate between both countries, provided there are no transportation costs in moving goods between both countries.
2. Asset Price Theory:
The theory states that currency is an asset just as real estate or securities or gold. The desire to hold a particular type of asset is driven by the perception of the asset‘s future value. If the value is likely to rise, people will want to buy the asset now and sell it at a higher price so as to make a profit. Conversely, if they think the asset‘s value will drop, all those holding the asset now will start selling the asset fearing a greater decline in price in the near future. Therefore, the asset‘s current attractiveness is a function of what the market believes its value is going to be in future. In other words, future expectations decide current buy/sell decisions.
This is true even for currency. If the market believes that the domestic currency is going to rise in value, everyone will start buying it. If the current exchange rate is Rs. 43/$, and the expectation is that the rupee will appreciate over the next six months. Participants will start purchasing the rupee and this will drive up demand. Because demand rises, the rupee will appreciate against the dollar, and the exchange rate will settle at Rs. 42/$.
If on the other hand, the market expects the rupee to depreciate, there will be selling pressure and the rupee will depreciate, probably settling at Rs. 44/$. At any point in time, the current exchange rate contains market expectations of the future value of the domestic currency.
3. Portfolio Balance Theory:
The portfolio balance theory connects money supply, supply and demand for domestic securities, demand for foreign securities, and the exchange rate.
Its assumptions are:
- Investors can hold only two types of assets—currency and bonds (domestic bonds issued in domestic currency and foreign bonds issued in foreign currency).
- Investors in two countries have identical asset preferences.
- When the wealth of investors in either country increases, they would prefer to hold more of the asset that they already hold in excess.
Investors in two countries prefer to hold more of bonds in the country where wealth (value of the portfolio) is higher when translated into domestic currency. This is called the preferred habitat version of the portfolio balance theory. Changes in money supply affect wealth which in turn, has an impact on the exchange rate. Open market operations bring about changes in money supply.
When a central bank conducts open market operations by buying domestic currency-denominated government bonds, money supply increases and the domestic currency declines in value (depreciates) against the selected foreign currency and the exchange rate changes. When the central bank buys government bonds their supply decreases. But since the domestic currency has depreciated, the domestic currency value of foreign currency-denominated bonds rises. This makes investors prefer foreign bonds to domestic bonds, and the demand for domestic bonds decreases.