Why the Exchange-Rate Regime Matters
A country’s exchange-rate regime determines how its currency’s price against another currency is set and what happens when market conditions change. Under a floating regime, the exchange rate can move as buyers and sellers respond to economic news. Under a fixed regime, the monetary authority commits to a target rate, so it must respond when market pressure would otherwise move the rate away from that target. The distinction matters because a shock absorbed by a currency movement under one regime may instead require changes in reserves, policy, prices, or economic activity under another.
To make the direction of these changes unambiguous, this tutorial uses the quotation \(e\) for the number of units of domestic currency exchanged for one unit of foreign currency. For example, if \(e=2.00\), one unit of foreign currency costs two units of domestic currency. An increase in \(e\) is a depreciation of the domestic currency: more domestic currency is needed to buy the same foreign currency. A decrease in \(e\) is an appreciation of the domestic currency.
A fixed rate may be stated against one other currency or against a group of currencies. A band allows the rate to move within specified limits rather than requiring one exact value. These arrangements differ in how much movement is permitted, but the central question remains the same: does the market determine the rate freely, or is there an official target that constrains it?
Market Equilibrium Under a Float
In a foreign-exchange market, demand for foreign currency comes from people or organizations that need it to make payments, acquire assets, or otherwise exchange domestic currency for foreign currency. Supply comes from those willing to exchange foreign currency for domestic currency. The market-clearing exchange rate is the rate at which the quantity of foreign currency demanded equals the quantity supplied. If demand rises relative to supply, the foreign currency tends to become more expensive in domestic-currency terms, so \(e\) rises. If supply rises relative to demand, \(e\) tends to fall.
A simple schedule makes this logic calculable. Let \(Q_d(e)\) and \(Q_s(e)\) denote the quantity of foreign currency demanded and supplied at exchange rate \(e\). The floating equilibrium \(e^*\) satisfies \(Q_d(e^*)=Q_s(e^*)\). At any other rate, the difference between these quantities indicates the direction of market pressure.
Worked Example: Finding the Market Rate and the Pressure at a Peg
Suppose a hypothetical market trades foreign currency in millions of units per day. Its schedules are \(Q_d(e)=160-30e\) and \(Q_s(e)=40+30e\). Find the floating equilibrium. Then calculate the imbalance if the authority instead sets a target of \(e=1.80\), and state the direction of pressure and the action needed to maintain the target. Use \(e\) in domestic currency per unit of foreign currency.
Method. First set demand equal to supply to find the floating rate. Then evaluate both quantities at the target and compare them. This avoids assuming that an official target automatically clears the market.
At a floating equilibrium,
Subtracting 40 and adding \(30e\) on both sides gives \(120=60e\), so \(e^*=2.00\). At this rate, \(Q_d(2.00)=160-30(2.00)=100\) and \(Q_s(2.00)=40+30(2.00)=100\) million units per day. The quantities match.
At the target \(e=1.80\), \(Q_d(1.80)=160-30(1.80)=160-54=106\), while \(Q_s(1.80)=40+30(1.80)=40+54=94\). Excess demand is \(106-94=12\) million units per day. Buyers want more foreign currency than private sellers are supplying. Left alone, that pressure would raise \(e\), depreciating the domestic currency. To keep the target, the authority must make up the shortfall by supplying foreign currency in exchange for domestic currency.
Check. The target is below the market-clearing value of 2.00, making foreign currency cheaper than at equilibrium. The resulting excess demand is consistent with upward pressure on \(e\).
How a Fixed Rate Is Maintained
At a fixed rate, the authority does not permit excess demand or excess supply to move the quoted rate freely. Instead, it must be prepared to meet the market imbalance or change conditions so that the target remains credible. When the market demands more foreign currency than it supplies at the target, the authority can supply foreign currency from its reserves and receive domestic currency. When the market supplies more foreign currency than it demands, the authority can buy the surplus and provide domestic currency. The later material on defending a peg examines foreign-exchange intervention in greater detail.
A target is therefore a commitment, not a guarantee that market forces disappear. The ability to maintain it can depend on available reserves, policy choices, and whether market participants believe the commitment will continue. If pressure persists, maintaining a fixed rate may require changes in domestic economic conditions. In some cases an authority may change the official target; an increase in \(e\) is a devaluation of the domestic currency, while a decrease in \(e\) is a revaluation. These official adjustments are distinct from routine exchange-rate movements under a float.
Worked Example: A Demand Shock Under a Float and a Fixed Target
A hypothetical foreign-exchange market has demand \(Q_d(e)=120-20e\) and supply \(Q_s(e)=20+20e\), measured in millions of units per day. Demand for foreign currency then increases to \(Q_d(e)=150-20e\), while supply is unchanged. Find the initial and new floating equilibria. Then calculate the imbalance at the original rate if the authority maintains the initial exchange-rate target.
Method. Solve the market-clearing condition before and after the shock, then hold the old rate fixed to quantify the pressure under the peg. The calculation separates a currency-price adjustment from the quantity imbalance at a fixed price.
Initially, \(120-20e=20+20e\), so \(100=40e\) and the initial floating rate is \(e_0=2.50\). The equilibrium quantity is \(Q_d(2.50)=120-50=70\) million units per day; supply is also \(20+50=70\).
After the demand increase, \(150-20e=20+20e\), so \(130=40e\) and the new floating rate is \(e_1=3.25\). The new equilibrium quantity is \(Q_d(3.25)=150-65=85\) million units per day, which matches \(Q_s(3.25)=20+65=85\). The domestic currency depreciates because \(e\) rises. The percentage increase in \(e\) is \((3.25-2.50)/2.50=0.30\), or 30%.
If the authority holds the original target \(e=2.50\), demand after the shock is \(150-20(2.50)=100\), while supply remains \(20+20(2.50)=70\). Excess demand is 30 million units per day. The authority must meet that gap or otherwise reduce the pressure if it is to maintain the target.
Check. At the new floating rate, both schedules give 85. At the old target, excess demand is positive, consistent with the upward pressure on \(e\) that a float would allow.
Adjustment After a Shock
The difference between the regimes is clearest when a market shock occurs. Under a float, a shift in demand or supply changes the market-clearing rate. That movement helps bring the quantities demanded and supplied back into equality. Under a fixed rate, the quoted rate does not make that adjustment; an imbalance must instead be accommodated by official transactions, changes in policy, or changes in economic activity and prices. Which channel is used depends on the circumstances and the regime’s institutional arrangements.
For example, stronger demand for foreign currency tends to raise \(e\) under a float, meaning domestic-currency depreciation. At a fixed target, the same demand shock creates excess demand at the target. The authority may supply foreign currency to meet it, but ongoing pressure cannot be ignored indefinitely: reserves are finite, and policy or economic conditions may have to adjust. Conversely, a rise in foreign-currency supply tends to lower \(e\) under a float. At a fixed target above the new market-clearing rate, the market has excess supply; maintaining the target requires the authority to absorb that surplus or to address the underlying pressure in another way.
A floating rate does not mean every shock is fully and instantly absorbed by the exchange rate. Trade volumes, prices, and financial decisions can adjust with delays, and a managed float may involve official influence. Likewise, a fixed rate does not imply that the economy is unchanged after a shock. It means the exchange rate is constrained, so other adjustment channels become more important.
Worked Example: An Increase in Foreign-Currency Supply
A hypothetical market has demand \(Q_d(e)=100-10e\) and initial supply \(Q_s(e)=10+10e\), with quantities in thousands of foreign-currency units per day. Export receipts then increase the amount of foreign currency offered in the market, shifting supply to \(Q_s(e)=40+10e\). Find both floating equilibria. If the authority holds the initial rate fixed, find the resulting excess supply and the direction of official action needed to maintain that rate.
Method. Solve demand equal to supply in each market, then evaluate the shifted schedules at the initial rate. This avoids confusing an increase in foreign-currency supply with an increase in demand for it.
Initially, \(100-10e=10+10e\), so \(90=20e\) and \(e_0=4.50\). The initial quantity is \(100-10(4.50)=55\) thousand units per day; supply is \(10+10(4.50)=55\).
After the supply shift, \(100-10e=40+10e\), so \(60=20e\) and \(e_1=3.00\). The new quantity is \(100-10(3.00)=70\) thousand units per day, also equal to \(40+10(3.00)=70\). The exchange rate falls, so the domestic currency appreciates. The percentage change in \(e\) is \((3.00-4.50)/4.50=-1/3\), a decrease of 33.33% when rounded to two decimal places.
At the old target \(e=4.50\), demand remains \(100-45=55\), while shifted supply is \(40+45=85\). Excess supply is \(85-55=30\) thousand units per day. That surplus puts downward pressure on \(e\). To maintain the target, the authority must absorb the surplus by buying foreign currency in exchange for domestic currency, or otherwise offset the pressure.
Check. At the new floating equilibrium, both quantities equal 70. At the old target, supply exceeds demand by 30, which is consistent with pressure for \(e\) to fall.
Deriving the Market Adjustment and Avoiding Common Traps
The direction of adjustment follows directly from the market-clearing condition. Suppose demand for foreign currency increases at every exchange rate while the supply schedule is unchanged. At the old equilibrium rate, demand now exceeds supply. Because buyers compete to obtain the available foreign currency, the price of foreign currency in domestic currency tends to rise: \(e\) increases. Along the supply schedule, a higher \(e\) encourages greater supply; along the demand schedule, it reduces the quantity demanded. Adjustment continues until the two quantities are equal again. This is why a demand shift produces a higher floating equilibrium rate in the examples above.
Under a fixed rate, the same logic identifies the imbalance but not a permitted exchange-rate movement. The target holds \(e\) constant, so the excess demand or excess supply has to be met or removed through another channel. The rate is fixed; the market pressure is not.
- Reversing the quotation. Here \(e\) is domestic currency per unit of foreign currency. An increase in \(e\) is domestic depreciation, not appreciation. With the reciprocal quotation, the direction would be reversed.
- Confusing a target with an equilibrium. A fixed target need not make demand equal supply. Calculate both quantities at the target before concluding that the market clears.
- Giving the wrong response to an imbalance. Excess demand for foreign currency calls for a source of foreign currency if the target is to be maintained. Excess supply calls for a buyer of foreign currency.
- Using the wrong percentage-change base. The percentage change from \(e_0\) to \(e_1\) is \((e_1-e_0)/e_0\), not \((e_1-e_0)/e_1\). Also state which currency is appreciating or depreciating under the stated quotation.
- Treating every float as unmanaged. Some regimes allow market movement while authorities still influence the rate. Describe the actual commitment rather than assuming all systems fit two perfectly pure categories.
Check Your Understanding
For each problem, use \(e\) as domestic currency per unit of foreign currency. Quantities are stated in the problem; identify both the arithmetic and the direction of adjustment where requested.
- A market has \(Q_d(e)=90-10e\) and \(Q_s(e)=10+10e\). Find the floating equilibrium rate and quantity. (Answer: \(e^*=4.00\); equilibrium quantity \(=50\) units.)
- At a fixed target \(e=3.00\), demand is \(Q_d(e)=110-15e\) and supply is \(Q_s(e)=20+15e\). Calculate the imbalance and state whether the target faces excess demand or excess supply. (Answer: both quantities are 65, so there is no imbalance at the target.)
- Initially, \(Q_d(e)=140-20e\) and \(Q_s(e)=20+20e\). Demand shifts to \(Q_d(e)=160-20e\). Find the old and new floating rates, the percentage change in \(e\), and the excess demand at the old rate. (Answer: \(e\) rises from 3.00 to 3.50, a 16.67% increase; excess demand at the old rate is 20 units.)
- Initially, \(Q_d(e)=120-10e\) and \(Q_s(e)=20+10e\). Supply shifts to \(Q_s(e)=50+10e\). Find the new floating equilibrium and the imbalance at the old rate \(e=5.00\). State the direction of pressure on \(e\). (Answer: the new equilibrium is \(e=3.50\) with quantity 85; at \(e=5.00\), excess supply is 30 units, putting downward pressure on \(e\).)
- A fixed-rate authority faces persistent excess demand for foreign currency at its target. Explain why stating the target alone does not resolve the imbalance, and name two broad ways the pressure might be accommodated or reduced. (Answer: the target does not itself make demand equal supply; the authority can supply foreign currency or policy and economic conditions can adjust to reduce the pressure.)