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Fixed and Floating
Exchange Rates
A2 Economics
A2 Economics
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PowerPoint Briefings 2006
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
United Kingdom - Effective Exchange Rate Index
Monthly averages, a rise in the index shows an exchange rate appreciation
115
110
105
Index
100
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Source: EcoWin
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 policymaking (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
China and the US dollar
China - US$ exchange rate
Average of daily rates, Chinese Yuan /US Dollar exchange rate monthly average
8.45
8.40
8.35
CNY/USD
8.30
8.25
8.20
8.15
8.10
China has been criticized by those who say its
fixed-rate monetary policy boosts exports by
keeping the yuan at a low level.
8.05
8.00
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Source: Reuters EcoWin
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 - Argentina
Argentina - Currency Board from 1991-2001
4.0 Argentina, Spot Rates, USD/ARS, Close 3.06
3.5
3.0
USD/ARS
2.5
2.0
1.5
1.0
0.5
0.0
90
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Source: EcoWin
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 freefloating 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
US Dollar- Russian Rouble Exchange Rate
Spot exchange rate, daily closing value, roubles per US dollar
35 Russia, Spot Rates, USD/RUB, Close 27.705
30
USD/RUB
25
20
15
10
5
0
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Source: Reuters EcoWin