Central Banking: Theory and Practice in Sustaining Monetary and Financial Stability

Chapter 9The Exchange Rate and Central Banking

Learning Objectives

• Explain how movements in the exchange rate can affect monetary stability, financial stability, and unemployment.
• Distinguish between a rigid peg, a free-float, and a managed float exchange rate regimes.
• Explain key theories that attempt to explain exchange rate determination.
• Identify key factors that can affect the exchange rate.
• Describe the way in which the central bank can influence the exchange rate.

At its core, the exchange rate is the price of money expressed in terms of another currency. Accordingly, the exchange rate is an important variable that the central bank must watch, even if the regime of that central bank does not involve exchange targeting. In Chapter 9 we will examine issues relating to the exchange rate in relation to central banking in more detail.

This chapter starts with a brief review of how the exchange rate might affect price stability, financial stability, and the real economy in theory and in practice. The chapter will then review the alternative exchange rate regimes, or frameworks, that a modern central bank can adopt. The exchange rate regimes that will be reviewed include the rigid peg regime, the free-float regime, and the managed float regime. Later on the chapter will review exchange rate theories so that the reader can see the fundamental forces that would influence the exchange rate in the absence of direct central bank intervention. The chapter will then review how ...