Setting a value for a currency: Interest rate, bank reserve ratio or pegging to a basket of currencies of major trading partners
Creators: name: Ng, Wenfa
Publisher: name: figshare
Year: 2017
Subjects: subject: 140210 International Economics and International Finance
subject: FOS: Economics and business
subject: FOS: Economics and business
subject: Economics
subject: 160401 Economic Geography
subject: FOS: Social and economic geography
subject: FOS: Social and economic geography

description: What is the value of a currency on a daily basis? How do we value a currency? Is it a fixed price relative to gold, as in the gold standard? In the era of semi or fully flexible exchange rates, prices of currencies move on a minute basis in currency exchanges, but what are the fundamental underpinnings of a currency, and how do we modulate its value for buttressing an ailing economy or cooling down an overheated one? Tackling this question, it is important to differentiate observed daily fluctuations of a currency’s exchange rate with that of its movement through monetary policy. Specifically, hourly or daily changes in a currency's value reflects either supply and demand dynamics of the currency or possible speculation. On the other hand, observing deviation of a country's economic indicators from its developmental trajectory or, more worryingly, initial signs of financial instability, central banks use monetary policy tools to provide support to a failing economy such as long term refinancing operations to support lending, or more commonly, making small adjustments to their chief lever, the benchmark interest rate. Yes, the price of a currency can be adjusted indirectly through the benchmark rate by modulating the demand of a country's currency. From a supply side perspective, other central banks are more in preference of using bank reserve ratio (or requirement) for changing money supply in the currency market. Specifically, in a high demand scenario, increasing money supply would ease pressure on the upward path of the currency's value. Finally, countries with an open economy and with trade as a main contributor to economic growth, find use of pegging their currencies’ exchange rates with a basket of currencies belonging to their major trading partners; thus, ensuring stability in trading conditions crucial for maintaining a country's status as a trading hub. However, such an implicit peg also subjects an economy to the dynamics affecting individual or a subgroup of the basket of currencies; for example, importing inflation from a trading partner, which meant paying a significant price for maintaining stable trading conditions (e.g., consistent price of currency between trading partners). Thus, how do we set the price of a currency? Interest rate is useful but slow and indirect, relying on influencing the financial market for adjusting the price of a currency. Bank reserve ratio, on the other hand, may be faster and more direct, but risk stoking a financial crisis by awashing a country's financial system with cheap money that may not find useful uses in funding enterprise or public investment, but eventually channeled into speculative activities. Finally, pegging a currency to a basket of currencies helps avoid the well-known dangers of a direct currency peg, where the smaller economy's fortunes moves in sync with those of the larger partner and opening the currency to speculative destabilization when the economy shows initial signs of shakiness. But it also meant paying a smaller but continuous price: in economic indicators such as inflation and financial flows not convergent with economic fundamentals of the country. Perhaps, aggregating a country's price for exports and imports and using terms of trade as a benchmark for suggesting a likely value of a currency in an open economy may be one way forward to solving this age old conundrum where we have moved from hard metal (gold) to flexible polymer money, and now, digital currency. Interested researchers may want to ponder and expand on research in this basic science issue of international and financial economics. <br><br>