IOE Tradeportal

Effects of Adjustment Mechanisms

The Spot exchange rate is used as a measure of the day-to-day value of one currency in relation to another and simplifies the process of foreign trading.

The Spot Rate is determined in the market by the pressures of supply and demand.

Demand for a currency results from payment for imports, outflows of capital in the form of short and long term investments, and financial transactions by banks.

In contrast, supply of a currency results from the level of exports and any inflows of capital, as well as bank dealings.

If disequilibrium in the balance of payments occurs there are adjustment mechanisms that can be used to try and achieve equilibrium.

Which mechanism is suitable depends on whether the disequilibrium is seen as of a short-term nature or more persistent, reflecting deeper economic problems.

The available adjustment mechanisms are:

reduce export prices
impose import tariffs
impose import quotas
intervention by central bank in FX market
intervention by central bank in money market

For an exchange rate mechanism to be efficient then it must meet the criteria of being able to correct disequilibrium without putting too much pressure on the domestic economy in terms of import costs, inflation, shortages, unemployment, etc.

For the central bank to be able to intervene in the FX markets it must have sufficient reserves of foreign currencies or gold. This will rarely be the case when international speculators 'gang up' on a currency.