Fixed and Floating Exchange Rate.

 

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FIXED AND FLOATING EXCHANGE RATES INTERNATIONAL FINANCE

 

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1 2 3

Evolution of IMS Flexible Exchange Rate Regime

Role of International

4

Effects of BOP on Exchange Rate System

5

Floating Exchange Rate

6

Fixed Exchange

7

Exchange Arrangements

 

INTERNATIONAL FINANCE

EVOLUTION OF INTERNATIONAL

 

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v Double

standard in that free coinage was maintained for both gold and silver  v Both gold & silver used as a means of international payment v The abundant metal was used as money E.g. When gold poured into the market in 1850s, the value of gold causing overvaluation of  gold under thedepressed, French official ratio, which equated a gold franc to a silver franc 15.5 times as heavy. So the franc became a gold currency

 

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  v Similar

to Gold Standard but now central banks’ reserves consist of gold and currencies. v As the gold standard, the gold exchange standard restrains excessive monetary growth throughout the world. v But it allows more flexibilit in the rowth

 

flexibilit

in the

rowth

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  v U.S. dollar is the reserve currency. v Every central bank fixes the dollar exchange

rate of its

currency through intervention. v Drawbacks of the Reserve-Curren Reserve-Currency cy Standard:  – U.S. occupies a special position because it never has to

intervene in the foreign exchange market  – US can use its monetary policy for macroeconomic stabilization

US has the affect itspolicy own economy, as well as foreign – economies bypower using to monetary  – Other central banks have to import the monetary policy of the US.  – This inherent asymmetry led eventually to policy

 

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FLEXIBLE EXCHANGE RATE v 1973

ttoo th e prese prese nt. v Af Aftt er th th e bre brea ku p of t he Br Bre tt on Woods sy syste m, th th e cu rr enc encii es o f th e indus industt riali rializze d co unt untrri es es’’ excch ange rate ex rate s were all all owed to to fl oat i n Ma rch 1 973 973.. v

Currencies of G U.S., Ge rma ny and reat Japan, B rit ain co nt ntii nues to to f lo at again again st eac eachh othh er to ot to th e prese prese nt.

 

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  Main goal of the IMF was:

Avoiding repetition of the chaos that occurred Avoiding between the wars through a combination of  discipline and flexibility

Discipline

Flexibility 

Mean that: •Need to maintain a fixed exchange rate put a brake on competitive devaluatio devaluations ns and brought stability to the world trade environm environment. ent.

Meant that: •While monetary discipline was a central objective of the agreement, a rigid policy of fixed exchange rates would be too inflexible. •IMF was ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficit, when a rapid tightening of  monetary or fiscal policy would hurt domestic employment

•fixed

exchange rate regime imposed monetary discipline on countries, thereby curtailing price inflation

 

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Rate the government or  central bank sets and maintains as the official exchange rate.

Determined by the private market through supply and demand

 

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EFFECTS ON BOP OF EXCHANGE RATE If currency value rises

If currency value falls

 

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FLOATING EXCHANGE RATE

 

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Monetary Policy Autonomy  v Freedom

(autonomy) for domestic monetary

policy v No

country is forced to import inflation (or deflation) from abroad.

v

possadjusted Flexibility the possibility ibility fortothe country’s country’s economy toand be quickly changing market conditions.

 

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Symmetry  Floating exchange rates remove two main asymmetries of the Bretton Woods system and allow: – Central banks abroad to

be able to determine their own domestic money supplies – The U.S. to have the same opportunity as other countries to influence its

 

exchan e rate a ainst forei n

  Exchange Rates as Automatic

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v Floating

rates promote swift and relatively painless adjustment to certain shocks in the goods market, such as a fall in foreign demand for the country’s exports. v Figure 1 shows that a temporary fall in a country’s export demand reduces that country’s output more under a fixed rate than a floating rate.

 

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v When

central banks are free from the obligation to fix their exchange rates, they might

embark on inflationary policies. v A stable (fixed) currency acts as a discipline on producers to keep their costs and prices down and may lead to greater pressure for exporters

 

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  Destabilizing speculation and v Floating

exchange rates allow

destabilizing speculation. §

Countries can be caught in a “vicious circle” of  depreciation and inflation.

v Floating

exchange rates make a country more vulnerable to money market disturbances.

 

  International Trade and v Trade

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and Investment:

 – Currency stability can help to promote trade and investment because of lower currency risk. –  – Exporters and importers and impo rters faceface lower exchange risk. International investments lower uncertainty about their payoffs. v Reductions

in the cost of currency

hedging  – With fixed exchange rates, businesses have to spend less on currency hedging if they know that the currency will hold its value in the foreign exchange markets (hedging involves risk)

 

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  The illusion of greater autonomy v Floating

exchange rates increase the uncertainty in the economy without really giving macroeconomic policy greater freedom.  – A currency depreciation raises domestic inflation due to higher wage settlements.

 

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Who Uses Fixed and Float List of exchange arrangements §

Floating rates are used by many countries • • •

Rich & poor  Large & small All over the world

§

Pegged rates are used mostly by small countries

§

Largest number of countries are between fixed and floating

 

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Exchan e Arran ements

 

Exchange Rate Regimes In Practice

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Currently: v14%

of IMF members follow a free float policy

v26%

of IMF members follow a managed float system v28%

of IMF members have no legal tender of  their own vRemaining

countries use less flexible systems

such as pegged arrangements, or adjustable pegs

 

Exchange Rate Regimes In Practice

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Exchange Rate Policies, IMF Members,

 

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Exchan e Rate S stem in India v Rupee

linked to GBP till 1975

v In

1975, Rupee was delinked from GBP and pegged to a multi currency basket of  currencies

v Devaluation v 1992

of Re in 1991

–India moved from fixed regime of  currency to a more controlled flexi regime, initiating liberalisation & globalisation.

 

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v Partial

convertibility of Re, 40% to be sold to RBI and 60% at market rates

v 1st

March 1993 – Re came to be traded freely in the market, subject to exchange control and trade control regulations

v USD

became the intervention currency

 

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EXCHANGE RATES AT 16.50

 

INTERNATIONAL FINANCE

Conclusion v Replacement

of new factors by new ones in the era of Globalization, Informatization and technical progress play the leading role.

v Need

v In

of greater flexibility.

case of poor economical policy and nonbalanced government management of the economy can reduce all the advantages of  flexibility.

 

INTERNATIONAL FINANCE

v Liberalization

of financial markets exceed the risks of instability, and the future is promising greater perspectives for the countries whose financial system is based on the floating exchange rate system

v Flexible

exchange rate system offers better  opportunities for successful economical  development than fixed exchange rate

 system.    system.

 

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Thank You ! Thank You