By domestic monetary policy — more inflation tends to mean a lower exchange rate as, without a

Depreciation, inflation hits the tradable sector more harshly than the non-tradable. (The tradable

Sector gets squeezed, as it has to hold its prices constant in world markets, while the domestic

Sector can raise its local prices in an inflationary environment more easily.) Representing such an

Important economic variable, governments have often sought to control exchange rates. It may be

Seen as the most effective means of stabilizing monetary policy, especially in smaller countries.

It may be to promote trade or international cooperation.

In the absence of government controls, there would be an entirely free or floating exchange rate

In operation. With a freely floating system, no gold and foreign exchange reserves would be required

As the exchange rate would adjust itself until the supply and demand for the currencies were

Brought into balance. There are merits in fixing exchange rates, or in adopting one of many hybrid

Systems which lie between these extremes. Fluctuations in the rate may be inconvenient for trading,

And these fluctuations could be volatile if left to move freely. Moreover, because of the pressure

Of short-term capital movements or speculation, the exchange rate could move in a direction different