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 in the Exchange
Markets the Interest Rates

• 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 by changing the
fundamentals

• 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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Inflation Puts Downward Pressure On the Exchange
Rate

• THE DEMAND SIDE
• 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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Inflation Puts Downward Pressure On the Exchange
Rate

• SUPPLY SIDE
• 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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EXAMPLE 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

1. 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

1. 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

1. The Mexican government soon runs out of reserves
   and lets the peso price fall.
2. 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?

• A pegged exchange rate sets a targeted value for
  a countrys foreign exchange, and the government
  can adjust the peg.
• The government may use an adjustable peg.
• or a crawling peg. The rate may be changed if
  there is a substantial disequilibrium in the
  countrys international position (e.g., demand
  for the currency is too weak to maintain the
  desired value).

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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

• 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.