Often exchange rates are set by the market forces of supply and demand. Later in the chapter, however, we will see that there is also considerable temptation for nations to purposefully manipulate currency values so as to achieve a desirable outcome for that state. At times, states (secretly) intervene in currency markets, buying up their own currency or selling it in an attempt to alter its exchange value.
A central bank will buy (demand) and sell (supply) enough of its own currency to
alter the exchange rate. At other times when the demand for the country’s currency declines, a central bank will use its foreign reserves to buy (demand) its own
currency, pushing up the value of its currency again.
Regardless of market conditions, for many states an undervalued currency
that discourages imports and increases exports can be politically and economically good for some domestic industries. This shifts production and international trade in that state’s favor. The dark side of currency depreciation is that when goods
such as food or oil must be imported, they will cost more if the currency is undervalued.
Undervaluation can also reduce living standards and retard economic
growth, as well as cause inflation. As we will see in the case of China (see the box The Tangled Web of China’s Currency Manipulation), many feel the nation has benefited more than lost from keeping its currency undervalued.
Sometimes LDCs overvalue their currency to gain access to cheaper imported goods such as technology, arms, manufactured goods, food, and oil. This may benefit the wealthy and shift the terms of trade in their favor. Although their own exported goods would become less competitive abroad, these LDCs could at least enjoy some imported items at lower cost.
In practice, it is hard for LDCs to reap the benefits of overvaluation in any meaningful way because their currencies are usually soft and not used much in
international business and finance. This does not stop them from trying, depending on political circumstances. In many cases, this invariably winds up choking domestic production and leaving the LDCs dependent on foreign sellers and
lenders for help. Agriculture seems to be especially sensitive to this problem. In some cases, developing countries with overvalued currencies have unintentionally destroyed their agricultural sectors and become dependent on artificially cheap foodstuffs.
In the 1990s, until the end of the decade, the value of the USD steadily climbed relative to the value of the currencies of many developing nations. While this helped the exports of the emerging nations, their consumers paid higher prices for
many technological imports and value-added products. To stabilize the relationship between the USD and other currencies, many countries decided to peg (fix)
their currency to the dollar. China pegged the yuan at 8.28 per USD. Because the
United States and the EU are major importers of Chinese goods, if the USD depreciated relative to the euro and most other world currencies, so did the yuan. While
the weaker currencies gained some stability in their relationship to the USD, developments in the U.S. economy were easily transferred into the developing nations,
depriving them of some flexibility in currency exchange rates.
Two other important issues are inflation and interest rates. All else being equal, a nation’s currency tends to depreciate when that nation experiences a higher inflation rate than other countries. Inflation—a rise in overall prices—
means that currency has less real purchasing power within its home country. This
