How Does the Government and Market Forces Influence the Rate (Level) of the Exchange Rate?
Governments can influence the level of the exchange rate directly or indirectly. Governments influence the exchange rate level directly by setting “fixed” exchange rates. This means that the rates stay at the same value until such time as a government sees fit to change them. For example, since 1994, China has fixed (pegged) its exchange rate relative to the U.S. dollar at 8.28 yuan = US$1. Governments influence the exchange rate level indirectly by changing interest rates (the amount of money in circulation) or by purchasing other currencies on foreign exchange markets (the place where different currencies are bought and sold). In addition, many countries, including the United States, Japan, and Canada, set “flexible” or “floating” exchange rates that change on a daily, or even hourly, basis, depending on currency demand and supply. Figure 1 illustrates how the U.S. dollar exchange rate for the European euro changed over the period 2001 to 2004. The downward sloping curve indicates a
