Money, Banking, and International Financetheir country's currency. Governments specify the rules and limits how people and businesses
can exchange its currency for other currencies. Furthermore, governments impose controls on
imports, exports, international investment, and foreign ownership of real estate, indirectly
influencing its currency exchange rates.
Government could implement a flexible exchange rate system, allowing the supply and
demand in the foreign-exchange markets to determine its currency exchange rate. Investors refer
to this as a free float or clean float because, government does not interfere with its exchange
rates. Although Canada, Eurozone, Japan, South Korea, and United States allow their exchange
rates to change, these countries occasionally intervene with their exchange rates. Unfortunately,
fluctuating exchange rates could hinder international trade and investment.
Most countries use a managed float, where a government allows supply and demand to
determine its currency’s exchange rate, but it intervenes to achieve economic policy goals. Of
course, if investors are pessimistic about a government’s ability to manage its exchange rate,
they call this dirty float. Usually, a government maintains either a too strong or a too weak
currency relative to the other currencies. Unfortunately, government intervention could lead to
depreciation. For example, if investors believe a country's currency will depreciate, then they
either cash out of that currency or buy derivative contracts. Consequently, investors can
overwhelm a government, forcing it to devalue its currency. Then investors’ expectations turn
into a self-fulfilling prophecy.
Some governments use a pegged exchange rate, where the government fixes its currency
exchange rate to a strong currency, such as the U.S. dollar or euro. For example, the United
Arab Emirates (UAE) set its exchange rate to one U.S. dollar to equal three UAE dirhams before
2008. Once the 2008 Financial Crisis struck the world, UAE devalued its currency to one U.S.
dollar to 3.67 dirhams. Other countries like Bahamas, Barbados, and Hong Kong peg their
currencies to the U.S. dollar while Bosnia and Herzegovina and Bulgaria fix their currency to
the euro. Unfortunately, a government must intervene in the currency market to maintain its
exchange rate. Countries like Uzbekistan and some African countries maintain exchange rates
that are too strong, but their central banks rapidly expand the money supplies, creating inflation.
Inflation can weaken a currency. Consequently, black markets form for their currencies because
the black market price reflects the true market value. A government can use a pegged exchange
rate to keep inflation in check if its central bank helps government finance its budget by
expanding its money supply.
Several countries use dollarization, where a country uses the U.S. dollar or euro as its own
currency. For instance, El Salvador, Ecuador, and Panama use the U.S. dollars as their own
currency. Furthermore, U.S. territories, such as Guam, Marshall Islands, U.S. Virgin Islands,
and Puerto Rico also use U.S. dollars. A territory is a country that was not admitted as a state to
the United States. Other countries, Kosovo and Montenegro, use the euro as their currency even
though they are not European Union members. Consequently, dollarization allows a country to
integrate its economy with United States or the Eurozone by tying its inflation rate to that
country. Dollarization also removes the exchange rate risk, but that country loses control over
monetary policy. Its central bank cannot collect revenue from seigniorage, when a government
earns a profit from printing money. For example, the Federal Reserve pays approximately 14