Exchange rate targeting

Definition

Exchange rate targeting is a monetary policy strategy where a country's central bank seeks to maintain the value of its currency within a specified range against another currency or a basket of currencies. This approach helps stabilize the economy by reducing exchange rate volatility, which can benefit international trade and investment by providing predictability for businesses and investors.

5 Must Know Facts For Your Next Test

1. Exchange rate targeting is often used by countries with less stable economies to provide confidence to investors and promote economic stability.
2. This approach can limit the central bank's ability to respond to domestic economic conditions since it must prioritize maintaining the target exchange rate.
3. When successfully implemented, exchange rate targeting can lead to lower inflation rates and enhance trade competitiveness.
4. However, if market forces push the currency away from the target, it may force the central bank to use substantial foreign reserves or raise interest rates to defend the target.
5. Countries employing exchange rate targeting often face challenges related to external shocks, as maintaining the peg can become increasingly difficult during economic turbulence.

Review Questions

• How does exchange rate targeting influence a country's economic stability?
  • Exchange rate targeting influences economic stability by reducing exchange rate volatility, which can encourage investment and trade. By maintaining a stable currency value relative to another currency or basket of currencies, businesses and investors can make long-term plans with more certainty. However, this strategy can also restrict a central bank's flexibility in responding to domestic economic conditions, potentially leading to conflicts between maintaining the exchange rate and achieving other economic objectives.
• Evaluate the advantages and disadvantages of using exchange rate targeting compared to a managed float system.
  • The advantages of exchange rate targeting include increased stability in international transactions and reduced inflation rates, which can foster a favorable business environment. On the downside, it limits a central bank's ability to react to domestic economic changes and may require substantial foreign reserves for maintenance. In contrast, a managed float allows for more flexibility in monetary policy as it adjusts according to market conditions but might lead to higher volatility in currency values, which can be risky for international trade.
• Critically assess how external economic shocks can challenge an exchange rate targeting policy and the implications for a country’s monetary policy.
  • External economic shocks, such as sudden changes in commodity prices or shifts in global demand, can significantly challenge an exchange rate targeting policy by causing pressure on the currency. If market forces push the currency away from its target, the central bank may need to intervene aggressively by using foreign reserves or adjusting interest rates. This situation can create tension within monetary policy as the need to defend the exchange rate may conflict with other goals like controlling inflation or supporting economic growth. Prolonged difficulties in maintaining the target could ultimately lead to a reassessment of the policy framework itself.

Related terms

Managed Float:

A system where a country's currency value is allowed to fluctuate in response to market forces, but the central bank intervenes occasionally to stabilize or influence the currency's value.

Currency Board: A monetary authority that maintains a fixed exchange rate between its domestic currency and a foreign currency, typically holding reserves in the foreign currency to ensure stability.

Pegged Exchange Rate: A type of exchange rate regime where a country's currency value is tied to another major currency, like the U.S. dollar, ensuring stability and predictability in international trade.