In our global economy, exchange rate policy is important

Switzerland is having currency problems. This may come as a surprise to many people since, unlike a number of other countries that are in the news these days, the Swiss have been financially responsible. However, as government debt problems have roiled many nations in Europe and the U.S. has struggled with its own government debt ceiling, many investors have turned to Switzerland as a relatively safe investment haven.

The problem with this from the Swiss point of view is what it has done to the exchange rate. Because investors want Swiss financial assets, the demand for Swiss francs on the world market has expanded dramatically. The result has been a surge in the value of the franc over other currencies. A franc is worth 50 percent more euros today than it was two years ago, and is worth almost 60 percent more dollars than it was in December of 2008.

For Swiss tourists and importers, this is a huge gain; their relative wealth has surged with the exchange rate, and foreign goods look much less expensive than they used to. For Swiss firms, this is a disaster. For their customers, the prices of their goods have risen right along with the value of the franc. As a consequence, sales and orders have dropped off dramatically.

As a result, Swiss policy makers have begun making public statement about a possible pegging of the franc to the euro. This would require a big increase in the Swiss money supply, but it would bring the exchange rate back down.

This is one recent illustration of the importance that exchange rates play in our modern economy. They are particularly important for smaller countries like Switzerland. Countries have a variety of options when it comes to exchange rate policy. All of these, however, are simply variations on two opposites. Countries can choose to fix their exchange rate to another currency or to a commodity (historically gold), or they can let the value of their currency float on the market.

Since the early 1970s, the Swiss franc has been a floating currency along with the other major "vehicle" world currencies, the U.S. dollar, the euro, the British pound and the Japanese yen. A floating exchange rate gives the central bank issuing the currency complete control over its own money supply. The bank may create more money when it feels the economy needs a stimulus, or create less money if they feel inflation is beginning to become a problem. However, the central bank cannot control the exchange rate in this case. Exchange rates in this case are set in the foreign currency market by the interaction of supply and demand for the domestic currency, and the central bank buys and sells in this market only rarely. Indeed, most central banks with floating currencies lack the foreign currency reserves needed to manipulate the exchange rate.