Principles and Policy of Economics - Essay Example

In a free economy, the exchange rate is floating in such a way that it is dependent upon supply and demand and there is no government intervention in the process. The exchange rate, under this classification, is determined by the increase in currency value can be seen because lower inflation equates to higher demand from such countries. A rise in the exchange rate also happens when demand grows slower as there is little importation happening. When investors are offered higher rates, these countries will attract more capital (Baumol and Blinder 758).

There is also another type of exchange rate system also known as the fixed exchange rate which is run according to the fixed rules set by the government. In this system, the balance of payments is important for financial experts to analyze the currency’s supply and demand. The basic principle is that sales and purchases must be equal. When the supply of the currency exceeds the demand, then there is a balance of payments deficit. When it is the other way, then there is a balance of payments surplus (ibid. 759). In the heyday of government intervention adhering to strict communist principles, the value of the Chinese currency was determined in impractical values in comparison to its western counterparts.

In 1978, the Chinese government put in place a dual-track currency system where its currency can only be used locally and foreigners must deal through forex certificates. The rules set in currency exchange were also too stringent that there was seen a growth in the black market exchanges. For some time from the mid-’90s till 2005, the yuan was pegged to the value of USD in answer to the 1998 Asian financial crisis. Then in 2003, the United States had the problem the Chinese exports became extremely competitive when the yuan and the dollar simultaneously dropped.

As a consequence, the EU and the g& called for a thorough exchange rate evaluation (Poleg n.p.).