Download fixed exchange rates

Exchange Rate Systems (HL only)
Fixed exchange rate system
A fixed exchange rate system is one where the value of the currency against other
currency remains exactly the same. It is set at a certain level against another
currency or basket of currencies. Many countries operated under a fixed exchange
rate system from 1944 (at the Bretton Woods Conference) until 1972 when the
system of fixed exchange rates broke down.
However, a fixed exchange rate can’t stay fixed all on its own! Governments/Central
Banks have to be ready to intervene maintain its fixed rate.
Assume that Azoraxia has ‘pegged’ its currency, the AZO to the US$ at a rate of 1
AZO = 2 US$, with the demand and supply given by D1 and S1 below. As long as
demand and supply are constant, then there is no problem in maintaining the fixed
rate. However, let’s say that Azoraxia is experiencing economic difficulties such as
high inflation. As a result of this, imported goods from the US become more
competitive against domestically produced goods and so Azoraxians wish to increase
their purchase of US imported goods. To do this, they must buy US$, and so they
have to ___________ AZOs. This is shown on the diagram below as an
_______________ in __________ from __________ to ____________.
If the currency were allowed to float, then we would see a ____________________
of the AZO. However, since the policy makers are commited to a fixed rate, they
cannot let it fall. At the original rate of 1 AZO = 2 US$, there is
____________________ of the AZO. In order to keep it at this fixed rate, the
authorities have to increase the ____________________ for the AZO.
There are different options:
1. The central bank can intervene on the foreign exchange market by
_______________________ of its own currency using its foreign reserves.
J. Blink, November 2009
2. If the central bank does not have sufficient reserves, then the only solution
would be to increase demand for the currency by ______________________
interest rates. The problem with this, however, is that __________________
_____________________________________________________________
3. Alternatively, the government might have to borrow money from abroad
(from other countries or the IMF). They could use these borrowed funds in
order to buy up their own currency. However, this only has limited value, as
the country cannot go on borrowing and borrowing if the downward
pressure continues.
Use the following diagram to show and explain what the authorities would have to
do in the event of rising pressure on the currency. This could be due to a persistent
increase in the demand for a country’s exports or a highly favourable
________________________ climate making it very attractive to buy shares in the
country’s firms (_________________________ investment) or making it very
appealing for multinational companies to set up productive units in that country
_________________ _________________ investment):
The high demand for the country’s exports and/or favourable investment climate
would result in an increase in the _____________ for the currency from _____ to
________. At the fixed exchange rate, there would be __________________. To
maintain the rate, the authorities would have to ___________________ of the
currency by:
1. ________________________________________________________
2. ________________________________________________________
3. ________________________________________________________
J. Blink, November 2009
If it becomes impossible for the authorities to maintain the value of the currency,
then they might have to make the decision to change the fixed value of the currency.
If they decide to fix the currency at a lower rate, this is called __________________.
If they decide to fix the currency at a higher rate, this is called __________________.
An alternate approach to a fixed exchange rate is to peg the currency to another
currency within a fixed band of values:
Advantages of fixed exchange rates

It removes the uncertainty associated with floating exchange rates. Fixed
rates provide stability for firms and households – this encourages investment
and trade.

A fixed exchange rate can act as a constraint on domestic inflation. Under a
floating exchange rate system, a country experiencing inflation will see a
falling value of its currency. However, if the currency is not allowed to
depreciate, (ie if it is fixed), then the inflation will make exports less
competitive and imports more attractive and therefore create downward
pressure on the currency. Therefore, the government would have to make it
a stronger priority to fight the inflation. This makes it less likely for a
government to pursue irresponsible fiscal policies, and forces them to adopt
fiscal ______________________.
J. Blink, November 2009
DISADVANTAGES OF FIXED EXCHANGE RATES

A government must maintain sufficient reserves of foreign currencies in
order to be able to intervene if necessary. There is a high
__________________ cost of doing this, as the money might be better used
for ____________________________________________________________.

Effectively, the central bank is no longer free to use monetary policy to
achieve domestic objectives. If there is sluggish growth, the central bank
might want to _______________________ the interest rate to raise
______________ and ______________________ the economy. However,
doing so would put ___________________________ pressure on the
currency, and so this would not be possible. Alternatively, if the country were
experiencing inflationary pressure, the central bank might want to ________
the interest rate to reduce ________________________. Again, this would
not be possible as it would put ______________________ pressure on the
currency. Thus, it could be said that domestic economic policies may have to
be sacrificed in order that the authorities are able to maintain the value of
the currency.
ADVANTAGES OF FLOATING EXCHANGE RATES

There is no need for the government to maintain large levels of reserves.

The government can pursue its own domestic policies without concern for
the effects on the currency.

Trade deficits (where the value of imports exceeds the value of exports) may
correct themselves automatically. If there is a trade deficit, the there will be
an increase in the __________________of the currency (to buy the imports)
and a ___________________in the demand for the currency (as less of the
country’s exports are demanded). Draw a quick sketch of this:
As a result, the currency will __________________________________. As
the currency depreciates, exports will become more ____________________
J. Blink, November 2009
and imports will become more ____________________________, thus
exports will rise, and imports will fall, eliminating the trade deficit
DISADVANTAGES OF FLOATING EXCHANGE RATES

The biggest disadvantage arises out of the uncertainty and risk in trade and
foreign investment associated with floating currencies. Uncertainty might
discourage international trade and foreign investment.

Floating exchange rates can lead to worsening inflation. If a country is already
experiencing inflation, then its exports will be _________ competitive. This
will lead to a ________ in demand for the currency and a ____________ in
supply for the currency. This causes the currency to depreciate which makes
imported_____________________. If a country has a high propensity to
import, or if the demand for imports is inelastic, then the __________ prices
of imported raw materials, machinery and technology can lead to
___________________.

Speculation on exchange rates can lead to major swings in the rates which
will cause further instability in trade and investment.

Governments may pursue irresponsible inflationary policies ( in order to
_____________________________) This will damage the economy in the
long run as the government will eventually have to deflate the economy, with
a resulting fall in output and rise in unemployment.
J. Blink, November 2009
A Single Currency (Monetary union) (Higher Level only)
The European single currency, the Euro, came into existence on January 1, 1999.
Eleven EU members joined – A_________, B_________, F__________, F__________,
G____________, I____________, I___________, L______________,
N_____________, P______________, S_____________. Since then several countries
have joined the Eurozone, including ______________________________________
_________________________________________, and there are also several
candidate countries, including ___________________________________________
________________________________________________________________
Convergence Criteria (Maastricht criteria)
To join the single currency, a country had/has to meet the following criteria:
 The government budget deficit must not exceed of GDP (which means it
cannot be a value which is greater than 3% of GDP)
 Government debt (accumulated deficits) must not be more than 40% of GDP
 A stable inflation rate and one which for at least a year before membership is
no more than 1.5% points above the average of the three member countries
with the lowest inflation rates
 A long term interest rate, which for at least a year before membership does
not exceed 2% points above the average of those countries with the lowest
inflation
 A stable exchange rate which for at least two years before membership has
stayed within the margins of the previous European Exchange Rate
Mechanism
Possible benefits of joining a ‘single currency’ (e.g. the euro)
 Reduced transaction costs: Firms and individuals save money as they do not
have to pay to change currencies as they move themselves or goods and
services within member countries.
 Increased transparency: With 11 national markets and 11 different
currencies, customers (firms or consumers) had imperfect information about
prices across the whole area. A single currency makes it easier for customers
to compare prices between different countries and buy from the cheapest
source. This makes it more difficult for multinational companies to price
discriminate between countries, charging higher prices in some countries
than others. The outcome may be lower prices, to the benefit of consumers.
 Lower inflation: Some countries, like Germany, were very successful in
fighting inflation. Others, such as Italy and the UK were less successful and
tended to have higher macroeconomic instability with wider fluctuations in
the business cycle. The European Central Bank takes a firm line against
inflation, and is to take action if inflation rises above the target rate of 2%.
 Macroeconomic stability: The requirements of Euro membership in
accordance with the Maastricht criteria along with the independence of the
ECB should mean greater macroeconomic stability, as governments are
limited from pursuing short-term politically-driven goals.
J. Blink, November 2009


Increased foreign investment: The exchange rate stability, certainty, reduced
transaction costs and large market size make Europe a more favourable
source of foreign investment than the independent markets.
More trade and greater economies of scale: Reduced transaction costs and
greater price transparency are likely to lead to increased trade among
member countries. This can lead to increased integration between firms
contributing to greater economies of scale.
Possible costs of joining a single currency
 Transition costs: These include psychological costs, e.g. resistance to change,
difficulties in adjustment and financial costs such as the costs of changing
vending machines and staff training. Some workers might lose jobs because
foreign exchange departments are cut in size.
 Loss of monetary policy independence: Members of the single currency can
no longer operate an independent interest rate policy and lose control of the
money supply. It is the ECB which controls monetary policy. This might be
problematic if a country is facing a different set of problems from other
members.
 Reduced fiscal policy independence: Euro members still have some
independent control of fiscal policy but this is limited by the need to make
sure that budget deficits do not exceed 3% of GDP. (Has this been followed?)
 Inability to manipulate the exchange rate to achieve other goals: A member
of the single currency cannot devalue its currency in order to increase the
price
J. Blink, November 2009