Fixed Exchange Rates vs. Floating Exchange Rates

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Fixed Exchange Ratesvs.Floating Exchange Rates
Global Trade Finance Phil Bryson
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Exchange Rate Regimes

• What are fixed Exchange Rates?
• - Officials commit to maintaining the exchange
  rate at a specific level.

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Exchange Rate Regimes

• What are Floating Exchange Rates?
• - No intervention from bankers or government
  officials. The market determines the price of
  the currency.

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Exchange Rate Regimes

• What is a clean float? A dirty one?
• - With a dirty float the government doesnt peg
  the currency, but tries from time to time to
  influence the rate by buying or selling in the
  currency markets.

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Fixed Exchange Rates

• How can the government keep a currency at a
  certain value if international commerce becomes
  unwilling to pay that price?
• It cant maintain the value for long. If the
  demand for the currency falls, its price would
  fall as well.

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Fixed Exchange Rates

• The only way the price can be kept up is for the
  government promising to maintain the original
  level to enter the foreign exchange market and
  bid the price of the currency back up by
  purchasing it.

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Fixed Exchange Rates

• The government must buy the amount that will
  bring the quantity demanded back to the original
  level.

Price of Franc
Supply of Francs
Demand for Francs
Quantity of exchange
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Fixed Exchange Rates

• To what does the government fix the value of its
  currency?
• When or how often does the country change the
  value of its fixed rate?

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Fixed Exchange Rates

• How does the government defend the fixed value
  against any market pressures pushing toward
  higher or lower exchange rate value?

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Fix to what?

• In the past, all currencies were fixed to gold.
• Today, a country can fix its value to another
  countrys currency.

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Fix to what?

• A country can fix its currency to a basket of
  other currencies.
• -Same as diversifying a portfolio (Not putting
  all your eggs in one basket)
• -Special Drawing Right (SDR)A basket of four
  major world currencies.

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Defending a Fixed Exchange Rate

• To buy or sell foreign currencies (in order to
  influence the prevailing exchange rate), a
  government must have foreign exchange reserves.
• It is not likely to have enough reserves to
  defend against a massive and sustained attack on
  the currency. What is an attack on a countrys
  currency?
• (Answer Massive selling off of a currency
  expected to be devalued. One can borrow the
  attacked currency and pay it back after
  devaluation.)

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Defending a Fixed Exchange Rate

• How can higher i rates keep the currency value
  up?
• (Answer Foreigners will purchase the nations
  currency, bidding its value upward, to make
  short-term investments in the country.)

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Defending a Fixed Exchange Rate

• The government can also make long-term
  adjustments of its macroeconomic (monetary and/or
  fiscal policy).
• Budget austerity avoids inflation and takes
  downward pressure off currency.

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Defending a Fixed Exchange Rate

• Why does inflation put downward pressure on a
  countrys exchange rate?
• Non-inflating countries are unwilling to pay more
  and more to buy an inflating countrys goods and
  services. Reduced demand for the inflating
  currency will make it depreciate.

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Defending a Fixed Exchange Rate

• Why does inflation put downward pressure on a
  countrys exchange rate?
• Citizens of the inflating country will want to
  seek bargains through imports, selling their
  currency to obtain other currencies. Selling
  increases the supply and drives the price down
  further.

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Defending The Peso Under Attack

• Assume the Peso has been inflating in Mexico
• Downward pressure will be on the peso. (Less
  demand for it, since fewer will be purchased with
  Mexican prices going up.)

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Defending The Peso Under Attack

• The Mexican government intervenes in currency
  markets, purchasing pesos to maintain their value
  and promises it will never permit its value to
  fall.

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Defending The Peso Under Attack

• The attack will be under way if people dont
  believe the promise. People sell their pesos for
  dollars, etc., while the price is still up. Note
  borrow money in Mexico, change it quickly for
  dollars. Pay back the loan later with cheap pesos.

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Defending The Peso Under Attack

• The Mexican government soon runs out of reserves
  and lets the peso price fall.
• People purchase pesos back at the new, lower rate
  for good gains.

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When to Change the Rate?

• Why might a government want to change the
  exchange value of its currency?
• It might do so in order to promote, for example,
  greater export volume.

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When to Change the Rate?

• What is a pegged exchange rate?
• The term pegged exchange rate refers to setting a
  targeted value for a countrys foreign exchange,
  and it indicates the govt. has some ability to
  move the peg.

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When to Change the Rate?

• Governments attempt to keep the value fixed for
  relatively long periods of time to reduce trade
  uncertainties.
• What is an adjustable peg?
• The government may change the pegged rate if a
  substantial disequilibrium in the countrys
  international position develops (e.g., demand for
  the currency is too weak to maintain the desired
  value).

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When to Change the Rate?

• A crawling peg can be changed often (monthly,
  say) according to a set of indicators or the
  judgment of the countrys monetary authority.
• Indicators
• The difference of inflation rates
• International reserve assets
• Growth of the money supply
• The current actual market exchange rate relative
  to the central par value of the pegged rate

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The Floating Exchange Rate

• Clean Float
• Supply and Demand are solely private activities
• Complete flexibility

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The Floating Exchange Rate

• Dirty Float (Managed Float)
• From time to time, the government tries to impact
  the rate through intervention
• More popular than clean float
• Effectiveness of intervention is controversial

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Monetary Policy with Fixed Exchange Rates
Expanding the Money Supply Worsens the Balance of
Payments
Capital flows out.
(in the short run)
To improve a poor macroeconomic situation, a
country increases its money supply so that banks
are more willing to lend.
The overall payments balance worsens.
Interest rate drops
The Current account balance worsens as exports
fall and imports increase.
Real spending, production, and income rise, but
The price level increases.
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Monetary Policy with Floating Exchange Rates
Effects of Expanding the Money
Supply
Capital flows out.
(In the short run)
Currency depreciation and automatic adjustment
begins!
The Current account balance improves
Real product and income rise more
Interest rate drops
With an increase in the money supply, banks are
more willing to lend.
Real spending, production, and income rise.
Current account balance worsens.
The Price level increases.
(Beyond the short run)
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In Conclusion

• Fixed exchange rates are government controlled.
• Floating exchange rates are market driven.

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In Conclusion

• Governments have always preferred the improved
  business climate of fixed rates
• They reduce the uncertainty of unstable currency
  values (note the European Monetary Systems fixed
  rates of the 1990s).

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In Conclusion

• But as financial markets have developed to
  accommodate for flexible exchange rates, more and
  more countries have come to appreciate the value
  of market determination.

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Readings Addendum

• The reading by Peter b. Kenen, fixed versus
  Floating Exchange Rates is probably expressive
  of a majority of economists.
• Once, during the era of the Bretton Woods System,
  many feared floating rates. Their uncertainty
  would hinder international trade

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Kenen on Fixed and Floating Rates

• Times have changed since the early 1970s and
  Nixons destruction of Bretton Woods. Markets
  have developed to hedge exchange risks and we
  have become accustomed to the uncertainties
  associated with them. Trade flourishes.

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Kenen on Fixed and Floating Rates

• Fixing the exchange rate deprives a government of
  two very valuable policy instruments, the nominal
  exchange rate and monetary policy, and it may
  therefore be tempted to adopt beggar-thy-neighbor
  trade policies to cope with output-reducing
  shocks.

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Kenen on Fixed and Floating Rates

• Fixing the exchange rate may help stabilize a
  country that has suffered extensively with
  inflation. trade policies to cope with
  output-reducing shocks.
• The commitment to a pegged exchange rate is
  implicitly a commitment to monetary and fiscal
  stability, without which a fixed rate cannot
  survive. Pegging can buy credibility.

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Kenen on Fixed and Floating Rates

• When asymmetric economic shocks trouble nations,
  some cannot cope without changing their exchange
  rates. It is neither wise nor realistic to
  advocate world-wide pegging.

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Richard N. Cooper on Exchange Rate Choices

• Many countries have gone to the float for their
  exchange rates, but many still decide to peg
  their currency or fix their exchange rate. The
  choice is probably the most important
  macro-economic policy decision a country makes.

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Richard N. Cooper on Exchange Rate Choices

• Cooper reviews the international monetary
  experience among the major countries, reviewing
  the reasons why floating rates were long viewed
  with suspicion.
• He discusses the Friedman/Johnson case for
  flexible rates made in the sixties and seventies.
  Johnson thought the developing countries would
  continue to peg their rates.

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Richard N. Cooper on Exchange Rate Choices

• Cooper reviews the potential pitfalls for
  developing countries when international
  institutions insist that they both move to
  greater exchange rate flexibility and to
  liberalize international capital movements at the
  same time.

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Richard N. Cooper on Exchange Rate Choices

• Flexible exchange rates have worked very well for
  the leading industrial countries. It will be
  interesting to see how Europe fares with
  absolutely fixed exchange rates among EU members
  (via the Euro) and how the Euro/U.S. Dollar
  relationship develops.

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Richard N. Cooper on Exchange Rate Choices

• Were still learning, but movements in exchange
  rates provide a useful shock absorber for real
  disturbances to the world economy, but they are
  also a significant source of uncertainty for
  trade and capital formation, the wellsprings of
  economic process.