Download 1. Setting the exchange rate

Poliitika ja majandus
kevad 2002
Arja Kiljunen
FIXED VS FLEXIBLE EXCHANGE RATES
Introduction
The reason why I chose the subject of exchange rate market, is that within the framework of our
course ‘Poliitika ja majandus’ an important interest concerns the functioning of the market.
Attention is paid to the role of the different actors including market forces and governments.
Exchange rate market is an interesting, but a very complex market. Because of the very nature of
the exchange market, it is inevitable that to some extent the international aspect will be emphasized.
International trade is more complicated compared to domestic trade not only because of the extent
of it. One major reason for it is that you are not dealing with a single currency. Different currencies
are used in global market. There is no national financial market of any significance that could be
totally isolated from the rest of the world. There is no global money which is accepted everywhere.
International trade involves currency exchange meaning that one currency is exchanged for another
in the foreign exchange market. The role of the exchange rates is essential because exchange rates
affect the value of all goods and services traded internationally. The more world trade has grown,
the greater have been the demand on the major currencies.
Challenging question concerning exchange rates is whether to choose fixed or flexible exchange
rate. For years there has been debate over fixed and floating exchange rates: which system is
superior one. National governments have been comparing advantages and disadvantages of each
system. The aim of governments is to ensure stable conditions in financial markets, to encourage
foreign trade and investment, and to promote the confidence of international financial environment
by preventing uncertainty. In this paper I will discuss the existing exchange rate arrangements, the
classification of exchange rate regimes, the choice of an exchange rate system and trends
concerning the exchange rate arrangements. Both systems - fixed and floating - have their
advocates. What are the merits and problems connected with each system? Why some countries
choose to peg their currencies and others prefer floating exchange rates? What is the trend of the
exchange rate arrangements? The aim of this paper is to answer the question: what is the
appropriate exchange rate arrangement?
In the twentieth century there have been different kinds of arrangements in the global financial
market and efforts to maintain order and stability in the international monetary affairs. One of the
most important aims has been the aspiration to stabilize international monetary relations. Big
changes have occured affecting financial markets and international trade. States have experienced
the gold standard with fixed exchange rates, the Bretton Woods system with pegged rates and
finally, freely floating exchange rates. Today’s reality in Europe is that most of the European Union
membercountries have replaced the monetary independence of their country with a common
currency, the euro, that is managed by the Central Bank of Europe. However, most national
governments continuously face the dilemma: fixed or floating exchange rates.
This paper consists of four parts. First chapter introduces the concept of exchange rate and discusses
the role of the market forces and national governments in the exchange rate market. Second part
concentrates on the classification of exchange rate systems. Third chapter discusses the choices of
the countries concerning the exchange rate arrangements. It includes also the comparison of fixed
and flexible rates. The last chapter concentrates on the trends of exchange rate arrangements.
1. Setting the exchange rate
This chapter discusses shortly the concept of exchange rate, the value of national currency and the
role of the market forces and national governments in the exchange rate market. What should be the
role of market forces and national governments in the exchange rate market?
In this paper I won’t concentrate on explaining the various details concerning the concept of
exchange rate. I give the most simple definition to it: the exchange rate is the price at which one
national currency can be exchanged for another. However, the exchange rate is a very unique and
special price because it affects many other prices, especially all goods and services traded
internationally. The exchange rate changes have also real effects on the general price level. The
value of national currencies like U.S. dollar, Japanese yen, pound sterling etc. are determined by
different actors. Two actors of the exchange rate market have to be taken specially into account
when comparing fixed and flexible systems of exchange rates: the market forces and national
goverments. What should be the role of national governments and market forces of supply and
demand at setting the exchange rate? Who should ‘make’ the exchange market?
Advocates of flexible exchange rates emphasize the role of the market forces. The exchange rate
should be formed according to supply and demand like all other prices are formed. Neoclassical
advocates of exchange rate flexibility argue that in the absence of the central bank intervention,
laissez-faire market forces ‘make’ the exchange market (Davidson 1992: 112). They favour a noninterventionalist policy towards the exchange rates and believe that market forces are better than
national authorities at determing prices (Kenen 1994: 141). Proponents of pegged exchange rates
argue that fixed exchange rates guarantee greater stability of the economic environment and reduce
uncertainty. In their opinion central banks have to intervene to maintain certain exchange rate and to
prevent national currencies from rising and falling against each other too much.
However, ”in reality as long as different national currencies are involved, fixed exchange rates are
never absolutely fixed” (Davidson 1992: 107). Even during the gold standard, the exchange rates
were allowed to fluctuate to some extent. Today there are classified different kinds of pegged
systems (see chapter 2) under which the value of currency may fluctuate within certain margins of
fluctuation around a central rate. When talking about flexible system it is often referred to
‘managed’ or ‘dirty’ floating which means that exchange rates are not absolutely determined by
market forces. Under modern floating systems central banks may intervene to smooth daily
exchange rate fluctuations.
2. The classification of the exchange rate regimes
This chapter concentrates on the classification of the exchange rate arrangements. The most simple
way to distinguish exchange rate systems would be the division into fixed and flexible
arrangements. In practice, however, the division is much more complicated. Since 1973, when the
Bretton Woods system collapsed and exchange rates began to float, countries have been adopting
different kinds of exchange rate arrangements ranging by degree of flexibility from single currency
begs to freely floating exchange rates. The classification introduced here is used by the International
Monetary Fund (IMF).
The IMF classification of exchange rate regimes was first introduced in 1975. The IMF member
countries are allowed wide freedom in their choice of exchange arrangements. However, members
are committed to collaborate with the IMF and other members ”to assure orderly exchange
arrangements and to promote a stable system of exchange rates” (IMF 1995: 17). When becoming a
member of the IMF, country is obliged to inform the IMF of its exchange rate arrangements within
30 days and also later during the membership in the case of any subsequent changes in its exchange
rate regime. It is emphasized that the role of exchange rate regimes is essential when creating a
favorable, stable and credible environment for international financial relations and global trade. One
particual obligation of the member countries concern especially exchange rate arrangements.
Members are obliged ”to avoid manipulating exchange rates or the international monetary system to
prevent effective balance of payments adjustment or to gain unfair competitive advantage over
other members” (IMF 1995: 17).
Different exchange regimes are classified according to the degree of flexibility in the system.
Arrangements are divided into three main groups: pegged exchange rate regimes, limited flexibility
(exchange rate is allowed to fluctuate within bands) and more flexible systems (IMF 1999: 24).
Under a pegged system it is possible to tie the currency to another country’s currency or currency
composite. In the case of a currency composite the currency is tied to a composite that is formed
from the currencies of country’s major trading partners. In 1975, there were 104 countries with
fixed exchange rate systems, out of which 81 were pegging their currency to a single currency (see
table 1). Corresponding figures in 1997 were 66, out of which 47 currencies were pegged to a single
currency. In 1975, there were 54 countries pegging their currency to U.S. dollar, 13 to French franc,
10 to pound sterling and four to other currencies (Baillie 1989: 7).
Second group includes the countris that are following limited flexibility. Limited flexibility means
that the value of the currency is maintained within certain margins of fluctuation. Under limited
flexibility the cooperative arrangements refers to the countries following the exchange rate
mechanism of the European Monetary System (EMS). The currencies of the members of the EMS
were jointly floating against other currencies (Note that today most of EU member countries, so
called euro-countries, are having a common currency, euro).
Table 1. Classification of IMF members’ exchange rate arrangements
Arrangement
1975
1990
1997
Pegged
104
89
66
81
45
47
to a single currency
to other composite
14
37
15
others
9
7
4
7
13
16
in terms of a single currency -
4
4
cooperative arrangements*
7
9
12
11
52
100
managed floating
-
23
54
independent floating
11
26
46
others
-
3
-
122
154
182
Limited flexibility
More flexible
Total
Source: IMF/International Financial Statistics (*refers to EMS).
Finally, there are countries with more flexible systems under which the exchange rates are floating
freely or the market determination is limited with central bank intervention. The difference between
managed and independent floating refers to a degree of market determination. In countries with
independently floating exchange rates, the exchange rate is determined mainly according to market
forces of supply and demand. In the case of managed floating, the central bank intervention is an
usual phenomenon. The central bank varies the exchange rate frequently (IMF 1999: 24). In 1975,
there were 11 countries following th policy of independently floating exchange rates. The figures in
1990 and 1997 were 26 and 46. In 1990, there were 23 countries having managed floating and 54
countries in 1997.
85,2 per cent of IMF member countries were following a pegged exchange rate regime in 1975.
More flexible system (all independently floating) was adopted by 9,0 per cent of member countries.
In 1990, these figures were 57,8 per cent and 33,7 per cent. In 1997, there were more flexible
currencies 54,9 per cent of all. Only 36,2 per cent of member countries were pegging their
currencies, out of which most were continuously pegged to a single currency. There has been
decline in the number of the countries with fixed exchange rates. Countries have been adopting
limited or more flexible arrangements. Many countries have chosen managed floating rather than
independently floating rates. However, countries with a single currency peg continue to follow the
fixed exchange rate policy (see chapter 3).
There have been some problems or shortcomings concerning above introduced classification. One
shortcoming is the fact that ”there is a wide spectrum of exchange rate regimes beyond the
traditional ‘fixed versus flexible’ exchange rate dichotomy” (IMF 1999: 28). Another shortcoming
is that some IMF member countries pursue the exchange rate policy different from the one they
have officially announced. For example, some countries are classified as ‘independently floating’,
but in reality the exchange rate is set by national government who is actively using the exchange
rate as a political instrument (IMF 1997: 79). In 1997 a new classification of IMF members’
exchange rate regimes was introduced by the IMF. According to this new classification system two
criteria is emphasized when classifying the exchange rate practices. First, exchange rate
arrangements are distinguished on the basis of the degree of flexibility of the system. This is similar
to the earlier classification. Secondly, the degree of independence of national monetary policy is
also taken into consideration (IMF 2000: 141-142). The new classification is based on members’
actual arrangements that may be different from officially informed arrangements.
3. The choice of an exchange rate system
One reason, why the discussion over the choice of an appropriate exchange rate arrangement
continus, is that the number of countries integrated in global market has increased in recent years.
Countries are involved in international environment with increasing trade, foreign investment and
international capital mobility. The member countries of the IMF are allowed to adopt exchange rate
arrangements of their choice. In this chapter I discuss the reasons for certain exchange rate
behaviour and policies that countries are following. Why some countries’ choice is to peg their
currency and others prefer more flexible exchange rates? Are there any systematic differencies
between countries which choose floating exchange rate regime and those with pegged currencies?
It is obvious that ”no single exchange rate regime is suitable for all countries or in all
circumstances” (IMF 2000: 7). The member countries of the IMF may adopt the exchange rate
arrangements of their choice (Kenen 1994: 151), but they are committed to inform the IMF about
exchange rate behaviour and policies. The choice of an exchange rate systems depends on many
specific domestic and external factors. It is natural that countries with different cultural and political
environment follow different policies. But what is the appropriate exchange rate arrangement?
The main argument of the advocates of fixed rates is that ”fixed exchange rates provide a firm and
reliable basis for international trade and international financial transactions” (Halm 1970: 5). Fixed
exchange rates increase economic policy credibility. The cost of the system may, however, exceed
the benefits when driving essential domestic policy changes to maintain the certain level of
exchange rate. Undesirable results in terms of unemployment and inflation may appear. The
advocates of fixed exchange rates often connect the flexibility with instability. Critics of flexible
exchange rates emphasize the possibility of destabilizing speculation. This means that speculators
cause exchange rate fluctuations which are much wider that without speculation. The uncertainties
associated with fluctuations may cause the shift for example from single-currency peg to basket
pegs or from more flexible system to limited flexibility. The proponents of floating exchange rates
argue that with fixed rates it is possible to achieve greater stability in the short run, but in the long
run there may appear increased instability (Kaufman 1992: 447). Small daily adjustments are more
preferable than wide periodic changes the advocates of flexibility say.
One advantage of the exchange rate flexibility is that countries can drive domestic policies
independent of the policies of other countries. Countries pegging their currencies to other countries’
currencies are obliged to follow other country’s monetary policy. They lose the domestic economic
autonomy. The problem is that to keep the exchange rate at the fixed level countries are sharing a
common inflation experience. With floating rates, each country may choose the rate of inflation
(Melvin 1992: 48).
However, fixed rates may be seen as an arrangement stabilizing inflationary tendencies. In the case
of many developing countries in the 1980s the inflation accelerated to very high rates compared
with their trading partners. Those countries were obliged to adopt pegged arrangements to stabilize
the trade conditions. Thus, the advantages of fixed rates have been relevant for countries suffering
from hyperinflation. ”Developing countries for the most part are not in a position to allow their
exchange rates to float freely as in the case of the major currencies” (IMF 1997: 82). The risk of the
emergence of domestic or external imbalances has increased because of the ever closer integrated
international relations and increased capital mobility. It is more difficult for many developing
countries to face these risks because their financial markets are not sufficiently developed.
One essential factor to influence the choice of the exchange rate regime is country size in terms of
economic activity and GNP. The larger the economy, the less dependent a country is when
concerning foreign exchange rates. Small countries tend to prefer fixed rates (see table 2). The
openness of the economy is also crucial. The openness refers to the country’s dependence on the
foreign trade. Country size and openness are related to each other. The more open the economy, the
more probable is that country prefers fixed exchange rate. Third factor taken into account is a
country’s production and export structure. If country has geographically concentrated trade, largely
with a single foreing trading partner, the tend is to tie its currency to the trading partner’s currency.
In practice this means a certain degree of stability which would not be achieved in the case of more
flexible exchange rates. Moreover, it is difficult to maintain the fixed exchange rate level when a
country is following higher rates of inflation than its trading partners. The less a country’s inflation
rate diverges from the inflation rate of its main trading partners, the more likely is the choice of
pegged rate (Melvin 1992: 49-51).
Table 2. Characteristics associated with countries choosing to peg or float.
Peggers
Floaters
- small size
- large size
- open economy
- closed economy
- harmonious inflation rate
- divergent inflation rate
- concentrated trade
- diversified trade
Source: Melvin, Michael: International Money and Finance 1992 (p. 50).
The country’s choice of exchange rate arrangement, however, doesn’t mean choosing between two
traditionally opposite possibilities, strongly fixed or fully freely floating rates, but ”there is a range
of regimes of varying degrees of exchange rate flexibility reflecting different intensities of official
intervention in the foreign exchange market” (IMF 1997: 83). Challenges that countris are facing
probably change over time. Thus, the changing environment where countries are acting have to be
taken into account when considering the shift from one form of exchange rate arrangement to
another.
4. Trends
There has been shift from fixed exchange rates toward flexible rates. In 1975, 85,2 per cent of
countries were having pegged currencies. The percentage of countries had declined to 36,2 per cent
in 1997. In 1975, only 9,0 per cent of all IMF member countries were following more flexible
exchange rate arrangements, all of them having independently floating currencies. In 1990, 33,7 per
cent of currencies were classified as more flexible ones and in 1997 the figure was 54,9 per cent.
The number of countries adopting intermediate arrangements have also increased. The shift has in
general been toward managed floating rather than toward an independent float. In 1990, 44,2 per
cent of all more flexible arrangements were managed floating and a half of all more flexible were
independently floating. By 1997, the percentage of countries following managed float had increased
to 54 per cent and the percentage of independently floating currencies had declined to 46 per cent.
Different factors have influenced the move toward more flexible rates. The changing economic
conditions and policy objectives of countries over time, the liberalization and globalization of
financial markets, and the accompanying increase in capital mobility have also had certain impact
to exchange rate arrangements. ”The emergence of tensions between the objectives of lower
inflation and external competitiveness over short time frames has been one significant factor in
countries adopting more flexible exchange rate arrangements” (IMF 1999: 38). In some cases the
shift has occured as a result of speculative attacks. Some countries have adopted more flexible
system as a result of a deliberate policy choice.
The shift to more flexible systems has been occuring both in the developed and developing
countries and by 1996, more flexible systems were dominant in all geographic regions of the world
(IMF 1997: 79). Among the emerging market economies the move to floating exchange rates has
been very clear. 41 per cent of transition economies that joined the IMF in 1992 pegged their
currencies to a single currency. In 1993 most transition economies joining the IMF pursued more
flexible arrangements. By 1997, 22 out of 26 had adopted flexible systems (IMF 1999: 23-24). ”The
increased preference for greater exchange flexibility has also been associated with the adoption of
more open, outward-looking policies toward trade and financial flows and an increased emphasis on
market-determined exchange rates and interest rates” (IMF 1997: 82). In the world of ever closer
international integration the risk of potential instability has also increased. The greater flexibility
can be seen as an instrument of adjustment.
Conclusion
Creating a favourable, functioning, stable and credible environment for international financial
relations and global trade, both systems - fixed and flexible exchange rate arrangements - have their
merits and shortcomings. However, it is clear that there is no single exchange rate system that
woudl be appropriate for all countries or in all conditions. It is also clear that in the world of
increasing global integration the division of exchange rates cannot be done into two traditionally
opposite groups - the purely fixed or absolutely freely floating exchange rates. The spectrum of
exchange rate arrangements is much wider.
Countries are facing changing challenges. The choice of exchange rate system in changing
international financial environment is a significant decision that has wide and far-reaching effects.
Since 1973, there has been shift from pegged exchange rates to more flexible rates. The move has
occured toward managed floating rather than toward independently floating exchange rates. This
shift has been occuring both in industrial world and in developing countries. Several transition
economies have also adopted more flexible systems. The existing system of flexibility is likely to
continue.
Countries that are pursuing pegged exchange rate policies tend to have small and open economies.
If a country’s foreign trade is concentrated on trade with a single country, it is probable that country
is tying its currency to trading partner’s currency. Larger countries with closed and diversified
economies are more likely to follow more flexible exchange rate arrangements. Countries with
fixed exchange rates are sharing the inflation experience of their trading partners, whereas countries
following floating rates have divergent inflation rates.
Literature list:
-Baillie, Richard; McMahon, Patrick (1989): The Foreign Exchange Market. Theory and
econometric evidence. Cambridge University Press.
-Blin, John M.; Greenbaum, Stuart J.; Jackson, Donald P. (1981): Flexible Exchange Rates and
International Business. British-North American Committee. Washington D.C.
-Davidson, Paul (1992): International Money&The Real World. Macmillan Academic and
Professional Ltd. London.
-Halm, George N. (ed.) (1970): Approaches to Greater Flexibility of Exchange Rates. Princeton
University Press. New Jersey.
-Kaufman, George G. (1992): The U.S. Financial System. Money, markets, and institutions.
Prentice-Hall, Englewood Cliffs. New Jersey.
-Kenen, Peter B.; Papadia, Francesco; Saccomanni, Fabrizio (ed.) (1994): The International
Monetary System. Cambridge University Press.
-Mayer, Thomas; Duesenberry, James S.; Aliber, Robert Z. (1990): Money, Banking and The
Economy. W.W.Norton&Company Inc. New York.
-Melvin, Michael (1992): International Money and Finance. Harper Collins Publishers Inc.
-Wonnacott, Paul; Wonnacott, Ronald (1990): Economics. John Wiley&Sons Inc.
-IMF: Issues in International Exchange and Payments Systems. April 1995. Washington D.C.
-IMF: World Economic Outlook. October 1997. Washington D.C.
-IMF: Exchange Rate Arrangements and Currency Convertibility Developments and Issues. 1999.
Washington D.C.
-IMF: Annual Report 2000.