What are the different types of exchange rate regimes?
SOME COUNTRIES have a fixed exchange rate, where they implement exchange-rate controls to maintain a fixed value for their currency, while other countries' exchange rates are floating, where there are less exchange-rate controls. For example, Barbados has a fixed exchange rate of two to one with the United States. To maintain this, Barbados exercises exchange-rate controls. For example, a citizen cannot purchase more than US$500 per day. This reduces the pressure on demand, which helps to keep the exchange rate at that particular level.
Jamaica, on the other hand, has a floating exchange rate. The exchange rate is determined by supply and demand. Though recently some commercial banks in Jamaica have been restricting the amount of foreign currency any individual can purchase to US$2,000 per day, the country's exchange rate continues to increase.
Is a high exchange rate dangerous?
Jamaica's exchange rate of $93.80 to US$1 may seem high, but there are many countries with higher exchange rates. Guyana's currency is the weakest in the Caribbean at $203.45 to US$1. In spite of this, their economy grew by 5.4 per cent in 2011.
Comparatively, Iran has the highest exchange rate in the world of $24,551 to US$1, followed by Somalia $23,000 to US$1, then Vietnam third with an exchange rate of $20,875 to US$1.
Despite having one of the weakest currencies in the world at the moment, Vietnam's economy grew by 6.8 per cent in 2010 and 5.9 per cent in 2011, and although densely populated with a labour force of more than 48 million, its unemployment rate is just 3.6 per cent. Commercial banks' prime lending rate is high at 16.26 per cent, similar to Jamaica's 17.4 per cent. Their public debt to GDP ratio is 48 per cent, far lower than Jamaica's 130 per cent.
However, the country has a strong manufacturing industry, which helps to earn foreign exchange.
What factors impact exchange rates?
There are a couple of factors that help to determine a country's exchange rate: inflation, interest rates, terms of trade, current account movements, public debt, political stability and economic performance.
Fundamentally, countries with high inflation rates normally have high exchange rates as well. Vietnam, for example, has the third-highest exchange rate in the world, also has a high inflation rate of about 18.2 per cent.
Jamaica also has a high inflation rate and a high exchange rate. Other countries with very low inflation rates, for example Switzerland's inflation rate of 0.2 per cent, has a correspondingly very low exchange rate, (just $1.09 to US$1 for Switzerland).
How is the dollar affected by interest rates?
Interest rates also have an impact on the value of Jamaica's currency, holding all other factors equal. When interest rates are high, investors should demand more Jamaican investments, because the rate of return is higher compared to other countries and, as a result, Jamaica's exchange rate should fall. However, in Jamaica and Vietnam, for example, interest rates are high and the exchange is also high. Therefore, the demand for investments are controlled by other factors including macroeconomic stability of the country.
Does economic stability count?
Countries with high inflation, high exchange rates, low GDP growth rate, high unemployment and poor infrastructural development are less likely to attract foreign investment. Countries like Jamaica, for example, with large public debt, is less attractive to foreign investors. Low demand for local investments means a low inflow of foreign currency, which does not improve the exchange rate.
Normally, countries like China devalue its currency, making its goods and services appear cheaper to foreigners so they sell more, which improves the country's economy. Unlike China, Jamaica will not benefit from such devaluations because the country does not produce enough to fulfil any increases in demand that may arise if its goods appear cheaper to the rest of the world.
What is the effect of trade?
High demand for foreign goods, relative to a country's supply of goods to foreigners, will have a negative impact on the exchange rate (current account). A deficit on this current account means Jamaica is spending more foreign currency than it is earning, since Jamaicans purchase more foreign goods than the country supplies abroad. This excess demand for foreign currency will increase the exchange rate.
The terms of trade, or relative prices, also affect the exchange rate. If prices are lower in Jamaica, relative to other countries, then the demand for Jamaican goods will increase and the Jamaican dollar should strengthen. However, this is not the case and the Jamaican dollar continues to lose value.
Dr André Haughton is a lecturer in the Department of Economics on the Mona campus of the University of the West Indies. Follow him on Twitter @DrAndreHaughton; or email firstname.lastname@example.org.