Question

Country \(X\) wants to lower the value of its currency on the foreign exchange market. Under a flexible exchange rate system, how can it do that?

Short answer

Country X can lower the value of its currency in a flexible exchange rate system by increasing the supply of its money in the foreign exchange market, which can be accomplished by selling more of its currency or by implementing an expansionary monetary policy.

Step-by-step solution

Understanding flexible exchange rate

Firstly, a flexible exchange rate is primarily determined by the foreign exchange market, relying on supply and demand. When supply overtakes demand for a currency, its value decreases. Conversely, if demand for a currency exceeds the supply, it becomes more valuable.

Lowering currency value

So, to lower the value of its currency, Country X needs to increase its supply in the foreign exchange market. This can be done by selling more of its currency than it buys, leading to a surplus of the currency in the foreign exchange market.

Impact of monetary policy

Country X may also boost the supply of its currency through monetary policy. It's central bank may pursue an expansionary policy, which entails lowering interest rates or purchasing government securities. This will increase the money supply and devalue the currency, making it more affordable.

Key concepts

Foreign Exchange Market

The foreign exchange market, commonly referred to as the Forex market, is a global decentralized platform where currencies are traded. It operates 24 hours a day and determines the relative value of currencies based on supply and demand.

In the context of a flexible exchange rate system like the one described for Country X, the currency's value is allowed to fluctuate freely without direct government-imposed restrictions. Market participants such as governments, central banks, financial institutions, and traders continuously engage in buying and selling currencies.

When Country X decides to lower the value of its currency, it must manipulate these market forces. By increasing the currency supply—perhaps by selling large amounts of its currency—it attempts to tip the balance in favor of supply over demand. This strategy results in a decreased currency value, making goods from Country X cheaper for foreign buyers and potentially boosting exports.

Currency Value

Currency value refers to how much of one currency can be exchanged for another. In a flexible exchange system, this value is not fixed and can change frequently according to market dynamics. Various factors impact currency value, such as:

• Economic performance
• Interest rate levels
• Political stability
• Market speculation

In Country X's case, to intentionally lower its currency's value, it needs to increase the currency's supply in the market. As supply rises, the value or purchasing power of the currency declines. Remember, a lower currency value can sometimes benefit a country's export industry by making its goods less expensive abroad, though it can also raise the cost of imports.

Monetary Policy

Monetary policy refers to the actions undertaken by a central bank, such as the Federal Reserve in the US or the European Central Bank in the EU, to influence a nation's money supply and interest rates.

For Country X, adjusting its monetary policy can serve as a tool to lower its currency value. An expansionary monetary policy, which involves increasing the money supply, is one effective method. This can be accomplished through actions like decreasing interest rates or purchasing government securities from the market.

By lowering interest rates, borrowing becomes cheaper, encouraging investments and spending. It can simultaneously spark inflationary pressures—too many goods chasing too little money. As a result, the increased monetary supply can lead to a devaluation of the currency in the foreign exchange market, exactly what Country X aims to achieve.

Interest Rates

Interest rates are the percentage charged on borrowed money, whether that be loans, mortgages, or otherwise. They are a critical tool in regulating economic activity and influencing currency value.

When Country X lowers its interest rates as part of an expansionary monetary policy, multiple effects ensue. Minimal interest rates make borrowing easier, thereby encouraging individuals and businesses to take loans and spend or invest.

However, for international traders, lower interest rates may make investments in Country X less attractive because returns from savings or investments are reduced. Consequently, the demand for Country X's currency may decrease in the foreign market, leading to a drop in its value. This strategic devaluation can prove beneficial for enhancing export competitiveness by making domestic products less costly abroad.