Fixed and Floating Exchange Rates

A2 Economics

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Exchange Rate Systems

• Countries can choose their exchange rate system:

• (1) Free-floating exchange rate

• (2) Managed floating system

• (3) Semi-fixed exchange rate system

• (4) Fully-fixed exchange rate system

• (5) Monetary Union with other countries

The Sterling Exchange Rate Index

Monthly averages, a rise in the index shows an exchange rate appreciationUnited Kingdom - Effective Exchange Rate Index

Source: EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Inde

x

80

85

90

95

100

105

110

115

Floating Exchange Rates

• The value of the currency is determined purely by market demand and supply of the currency

• No target for the exchange rate is set by the Government

• There is no need for official intervention in the currency market by the central bank

• Sterling has floated freely on the foreign exchange markets since the UK suspended membership of the ERM in September 1992

Managed Floating Exchange Rate

• Currency is usually determined by market forces

• Some currency market intervention might be considered as part of demand management

• Interest rates may be changed to affect the market value of the currency

• No attempt is made to influence the long-term external value of the currency

• There are limits to the effectiveness of intervention in markets

Semi-Fixed Exchange Rate

• The exchange rate is given a specific target

• The currency can move between permitted bands of fluctuation on a day-to-day basis

• Exchange rate becomes an target of monetary policy-making (e.g. interest rates are set to meet the exchange rate target such as when the UK was in the ERM).

• The central bank must intervene to maintain the value of the currency within the set targets if it moves outside the agreed range

• Re-valuations of the currency are seen as a last resort or when intervention is proving ineffective

Fully-fixed exchange rate

• Commitment to a fixed exchange rate

– The exchange rate is pegged

– There are no fluctuations from the agreed central rate

• Examples?

• This system achieves exchange rate stability but perhaps at the expense of domestic macro stability

• A country can automatically improve its competitiveness by reducing its costs below that of other countries – knowing that the exchange rate will remain stable

Average of daily rates, Chinese Yuan /US Dollar exchange rate monthly average

China - US$ exchange rate

Source: Reuters EcoWin

95 96 97 98 99 00 01 02 03 04 05

CN

Y/U

SD

8.00

8.05

8.10

8.15

8.20

8.25

8.30

8.35

8.40

8.45

China and the US dollar

China has been criticized by those who say its fixed-rate monetary policy boosts exports by keeping the yuan at a low level.

Currency Boards

• Currency board: a country commits, by law, to exchange domestic currency for a specified foreign currency at a fixed rate.

• Example:

• Argentina adopted currency board between 1991-2001 when one peso can be exchanged to one dollar.

• To maintain the currency board arrangement, the constitution of Argentina specifies that the amount of domestic money supply cannot exceed the country’s foreign reserves.

Currency boards - ArgentinaArgentina - Currency Board from 1991-2001

Source: EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

US

D/A

RS

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0 Argentina, Spot Rates, USD/ARS, Close 3.06

UK Economic History

• 1973-1990: UK operated with a managed floating exchange rate. There was some intervention by the central bank to influence the exchange rate and government was in control of interest rates

• October 1990- September 1992: UK a member of the European exchange rate mechanism (ERM) – the exchange rate was a specific target of economic policy

• September 1992 – present day: the UK has operated with a free-floating exchange rate – no intervention by the Bank of England. Exchange rate is purely market determined

• Since 1999, the Euro has been in existence as twelve nations have established a single currency. Sterling floats freely against the Euro and also against the dollar, yen etc.

The ERM experiment

• Britain entered the ERM in October 1990

• The main aims were to

– (i) Achieve exchange rate stability to promote trade

– (ii) Provide an anchor for Monetary policy in order to bring down inflation – the UK was fixing sterling against the low-inflation German economy

• Under the ERM UK interest rates had to be set at a level consistent with keeping sterling at agreed levels (DM 2.95)

• But the weakness of the British economy (recession, rising unemployment and a housing recession) meant that interest rates were probably too high for our own needs

• Inflation came down but sterling was weak

• The speculators attacked!

Coming out of the ERM – Sept 1992

Counting the cost of leaving the ERM

• Treasury notes – published in February 2005(!)

• On Black Wednesday itself, September 16, 1992, the Bank of England sold some $28 billion of official foreign reserves trying to keep sterling within its ERM target range

• This intervention failed and sterling was forced out of the ERM and allowed to float freely

• Advantages:

– A lower pound boosted the competitiveness of exporters

– Interest rates could now come down in order to provide a boost to aggregate demand and take the British economy out of recession

– Fears of rising inflation proved unfounded – there was plenty of spare capacity in the British economy at the time

Evaluating exchange rate systems

Fixed versus floating rates

King on exchange rate regimes

• Countries have always faced constraints in choosing their exchange rate regime.

• Any country can have only two out of the following three:

– an independent monetary policy

– a fixed exchange rate

– an open capital account.

– As international financial markets have developed, there has been a general movement to flexible exchange rates supported by credible domestic monetary policies. That is a sensible use of the price mechanism to respond to complex and unpredictable shocks.

The Case for Floating Rates

• Less need for currency reserves for use in intervention

• Useful instrument of macroeconomic adjustment e.g. a lower currency can stimulate aggregate demand

• Provides partial “automatic correction” for a trade deficit

• Reduced risk of currency speculation

• Freedom (autonomy) for domestic monetary policy

• Floating exchange rates are not always volatile exchange rates!

The Case for Fixed Exchange Rates

• Stability - helpful for trade and capital investment

• Some flexibility (i.e. the occasional devaluation or revaluation of the currency – known as “realignment”)

• Reductions in costs of currency hedging for businesses

• Fixed rate provides a discipline on domestic producers to keep costs and prices down and to raise productivity

• Reinforces gains in comparative advantage:

– If one country has a fixed rate with another, then differences in relative costs will quite easily be reflected in changes in the rate of growth of exports and imports

Dollar-Rouble

Spot exchange rate, daily closing value, roubles per US dollar

US Dollar- Russian Rouble Exchange Rate

Source: Reuters EcoWin

92 94 95 96 97 98 99 00 01 02 03 04 05 06

US

D/R

UB

0

5

10

15

20

25

30

35 Russia, Spot Rates, USD/RUB, Close 27.705