Exchange rates: the second pillar of the ECB’s monetary policy

The European Central Bank (ECB) is not limited to managing interest rates. Another fundamental aspect of its mission is to ensure the stability of the euro on the foreign exchange market, i.e., in relation to other currencies. This action aims to preserve the credibility and competitiveness of the euro in international trade.

I. The Exchange Rate: Definition and Role

The exchange rate represents the value of the euro relative to other currencies. The ECB closely monitors these rates and can intervene in the foreign exchange markets by using its foreign currency reserves. Its goal is to ensure that the euro remains a stable currency suited to global economic realities.

1. Fixed vs. Floating Exchange Rates: Two Monetary Regimes

There are two main systems for determining the value of a currency: floating and fixed exchange rates.

In a floating exchange rate system, the currency’s value is determined freely by the market, based on supply and demand on the foreign exchange market. This value can appreciate or depreciate depending on trade flows, investments, interest rates, and the confidence of economic actors. This system is the most widespread today. The euro, the dollar, the yen, and most major currencies operate this way.

In a fixed exchange rate system, the central bank sets a parity between its currency and another currency, for example, a specific exchange rate between the Danish krone and the euro. It commits to maintaining this parity by regularly intervening in the foreign exchange market to buy or sell its own currency. This system offers some stability, but it is costly and difficult to maintain, especially during economic crises or massive capital movements.

2. Useful Vocabulary for Understanding Currency Variations

It is important to distinguish the terms used depending on the exchange rate regime. In a floating regime, the market determines the currency’s value. We speak of appreciation when the currency gains value and depreciation when it loses value. In contrast, in a fixed regime, the central bank voluntarily adjusts the parity. We speak of revaluation when the currency is given a higher value and devaluation when its value is lowered.

3. Why is a Fixed Exchange Rate System Hard to Maintain?

Imagine a country like Mexico decides to peg its currency to the euro’s exchange rate. To maintain this parity, the central bank must be ready to intervene on the foreign exchange market at any time. If investors lose confidence and sell the national currency en masse, its value drops. To prevent this rate from falling, the central bank must buy its own currency using its foreign currency reserves. These reserves are limited. Once exhausted, the central bank can no longer defend the exchange rate, and the currency is devalued. Several Latin American countries experienced this type of crisis in the 1980s. This is why most countries have adopted a floating exchange rate regime.

4. The Advantages and Disadvantages of a Strong Currency

A strong currency has several advantages. It reduces the cost of imports, which limits price increases for consumers and helps contain inflation. It also strengthens purchasing power abroad, facilitating international travel and investments for individuals and businesses.

Example 1: A European company imports smartphones made in the United States. If 1 euro is worth 1.20 dollars, a smartphone costing 1000 dollars in the United States will cost the European company 833.33 euros (1000 / 1.20). If the euro weakens and 1 euro is now worth 1.10 dollars, the same smartphone will cost 909.09 euros (1000 / 1.10).

The strong currency allowed the company to buy the product cheaper. This lower import cost can be passed on to the final selling price of the smartphone in Europe, which limits price increases for consumers and helps maintain low inflation.

Example 2: Assuming an exchange rate of 1 CHF = 1.06 EUR, a tourist exchanges 1,000 CHF and receives 1,060 EUR. If the Swiss franc weakens and 1 CHF is worth only 1.02 EUR, the same 1,000 CHF will only give him 1,020 EUR.

Thanks to his strong currency, the Swiss tourist has greater purchasing power in Europe. His initial 1,000 CHF allow him to spend more on accommodation, food, or activities because each franc exchanged brings him more euros.

However, a strong currency can also penalize exports by making products more expensive on foreign markets, which can weigh on the competitiveness of companies and slow economic growth.

Example: A German company manufactures cars and sells them on the American market. The selling price of one model in Europe is 40,000 euros.

• With a weak euro (1 € = 1.10 $), the price of the car for an American buyer is 44,000 $ (40,000 € x 1.10).
• With a strong euro (1 € = 1.30 $), the price of the same car for the American buyer climbs to 52,000 $ (40,000 € x 1.30).

Impact: The strong currency made the German car 8,000 $ more expensive for Americans. Compared to Japanese or Korean competitors whose currencies are weaker, the German manufacturer loses competitiveness, sales can fall, and it is forced to either lower its prices (which reduces its margin) or lose market share.

II. The Special Case of Switzerland: When Money Costs Almost Nothing

Switzerland is a perfect example of a very accommodative monetary policy with interest rates close to zero, or even negative, for several years. This situation means that the Swiss National Bank (SNB) lends money to commercial banks at an extremely low cost, which translates into inexpensive loans for households and businesses. Specifically, borrowing money to buy real estate or finance a project is made very accessible, thereby encouraging consumption and investment.

However, this policy also has consequences for savers: saving money earns little, which encourages them to seek riskier investment alternatives or to prioritize spending. Furthermore, the strength of the Swiss franc, considered a safe-haven currency in times of global economic uncertainty, puts pressure on Swiss exports, making their products more expensive abroad. To limit this appreciation of the franc, the SNB maintains low rates to discourage speculative flows and support the national economy.

Thus, saying that “money costs nothing” in Switzerland reflects a monetary strategy aimed at balancing the effects of a strong currency by facilitating low-cost credit to preserve economic growth while facing the specific challenges of this particular context..