How can exchange rate policies be used to reduce trade imbalances?

A fixed exchange rate policy generally suggests the central bank sets a specific value for the domestic currency against another currency - or a basket of currencies - and the CB intervenes in the foreign exchange market to maintain that “fixed” value.

I agree, A fixed exchange rate policy means that the government or the central bank sets a specific value for the domestic currency against another currency or a basket of currencies, and intervenes in the foreign exchange market to maintain that value. This policy can help reduce trade imbalances by stabilizing the prices of exports and imports, and by attracting foreign investment and tourism

Fixing the exchange rate can be a dangerous thing to do. In the end an exchange rate is the relative price of two monies, which normally reflects the relative price levels in the two currency areas. Once you fix the price (in any market), the resource allocation will become inefficient. Temporarily a fixed exchange rate regime can be useful, of course, for instance on the way to a common currency area or when FX volatility is too high and hampers trade with foreign partners.

A floating exchange rate refers to an exchange rate system where a country's currency price is determined by the relative supply and demand of other currencies. Currencies with floating exchange rates can be traded without any restrictions, unlike currencies with fixed exchange rates. A fixed exchange rate is a regime applied by a government or central bank that ties the country's official currency exchange rate to another country's currency or the price of gold. The purpose of a fixed exchange rate system is to keep a currency's value within a narrow band.

A fixed exchange rate regime can have a specific value against another currency, or a band in which the currency is allowed to float freely. Below are three examples of fixed exchange rate regimes in 2023: 1) In the UAE, the United Arab Emirates dirham is pegged the the USD at 1 USD = 3.6725 AED. 2) However, in Denmark, the Danish krona is pegged with the EUR at 1 EUR = 7.46 DKK, but the currency is allowed to float within 2.25% of that rate. 3) In Hongkong, the Hong Kong dollar is allowed to float between 1 USD = 7.75 HKD and 1 USD = 7.85 HKD.

A flexible exchange rate policy means that the central bank lets the market determine the value of the domestic currency against other currencies, and does not intervene in the foreign exchange market.

Under a flexible exchange rate system, the market forces are empowered to dictate the domestic currency value against foreign currencies. The flexible rate policy reduces trade imbalances by securing domestic prices - as the forces of demand and supply determine the domestic prices, and guaranteeing international competitiveness.

A managed exchange rate is controlled by the central bank and contains elements of both a fixed and floating exchange rate.

Managed exchange rate policies offer a nuanced approach to rectifying trade imbalances by blending elements of fixed and flexible rates. Drawing from my professional observations, such strategies enable governments to prevent extreme currency valuations, influencing trade dynamics. For instance, a country I analyzed adjusted its exchange rate to make exports more competitive, thereby reducing its trade deficit. However, this approach demands careful balance. Over-intervention can breed market uncertainty, undermining investor confidence and financial stability. Thus, while effective, managed exchange rates require careful, strategic application to ensure economic equilibrium.

In developing and emerging economies, we tend to see more exchange rate management and intervention from the central banks than in developed economies, which often have a free-floating exchange rate policy. In fact, developing economies are more fragile and often rely on foreign investments for their growth. This makes them vulnerable to strong capital outflows and inflows from worldwide or foreign events, especially because the size of their economy is usually small and it is perceived as riskier in times of uncertainty. Their currency could depreciate or appreciate quite sharply without exchange rate intervention or capital movement restrictions.

Between floating and fixed exchange rate regimes there are in-between variations. I will focus on floating regime. For instance, free floating exchange rate is used mostly by developed countries where liquidity is high and currency volatility is low. Central banks can intervene in the FX market but they do it rarely and only when it is necessary, by using their foreign exchange reserves and by raising or lowering interest rates. While, in some other countries, currency exchange rates are more actively managed by the Central Bank. This might be beneficial for export-oriented economies in order to make their exports more competitive in the foreign market.

Nigeria for instance, has recently transitioned from a multi-exchange rate system, where the central bank dictated the official rate and a higher unofficial rate impacted commodity prices, especially for imports like wheat. Now, the exchange rate will be market-driven, a move anticipated to boost inflows and stabilize an economy facing inflation and high unemployment. Hopes are high that this shift will help woo investors (who have exited the country en-masse in recent years) and further contribute to stabilizing the local currency. While this move promotes market fairness by eliminating distortions, it may lead to increased costs for imported goods, impacting a nation heavily reliant on imports.

In our current global economic setting, both small and large economies are susceptible to external and domestic shocks. However, smaller economies are more susceptible than the larger ones. Citing Uganda as a model small and open economy, the country shifted to a flexible exchange rate regime in 1993 to ensure domestic price stability and stable international trading terms.

Exchange rates are extremely important, whether they’re fixed or floating, for the global economy. They’re actively traded, included in capital management strategies, etc.

The exchange rate used to be the valve to release pressure on the economy. Now, nobody really likes this kind of fx reaction as a weak currency is a reflection of bad policies, or even worse, of unfavourable structural developments. Hence the temptation to intervene, which usually has been a bad idea historically.

First of all, it’s key to realise that “trade imbalances”, as described in the original post, aren’t inherently good or bad. Now there’s fixed, floating and managed FX policies. What needs to be considered in the overall picture is “interest rate differentials”, as this’ll impact currencies, and nicely ties in with trade imbalances. As investors seek yield, they’ll put their money in countries offering a good yield, once you factor in risks (liquidity risk, default risk etc.) Those securities will be in the domestic currency, so you see the demand of that currency going up and that currency strengthening. Currency strengthening = imports cheaper & exports dearer Monetary policy feeds into FX which can feed into trade imbalances

Exchange rate policies can be employed to address trade imbalances by influencing the value of a country's currency relative to others, this could be achieved by currency appreciation or depreciation and/or adjusting interest rates, whereas higher interest rates attract foreign hot money, leading to an appreciation of the currency. Also, targeting a specific inflation rate can indirectly affect exchange rates. If a country targeting a low inflation, its exports will be more competitive and in turn its local currency exchange rate should appreciate.

Past observation of my country in 1997, a tremendous change from the era when exchange rate capped by Government and then the 1997 economic crises served as a wakeup call to regulator and industry. Exchange rate policy from managed float to free floating regime. During the Currency Managed Float Regime (“Dirty Float”), regime central bank plays significant role in determining the exchange rate. While during the Currency Free Floating (“Clean Float”) the market forces of supply and demand determine rates. In this system exchange rates fluctuate over time. It impacted the change of interest rate regime that further become instrumental for monetary policy and has implications for trade balances as well as the currency determined by market.