Fixed Exchange Rates There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is is
pegged. Floating Exchange Rates Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. Look at this simplified model: if demand for a currency is low, its i ts value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.
In reality, no currency is wholly fixed or floating. fl oating.
The disadvantages of a fixed exchange rate system The loss of monetary policy policy As the UK government found when they were part of the ERM, a commitment to a fixed exchange rate means means that you lose control over all other instruments of monetary of monetary policy. policy. Although the government pretended that UK interest rate decisions we still their own (and technically they were) any movement of the German interest rate was usually quickly followed by a similar change in the UK. Today the Monetary Policy Committee (MPC) can set interest rates at whatever level they want, but they cannot control the value of the pound at the same time. Controlling one of these two instruments means a loss of control of the other.
EXCHANGE RATES UNDER FIXED AND FLOATING REGIMES REGIMES With floating exchange rates, changes in market demand and market supply of a currency cause a change in value. In the diagram below we see the effects of a rise in the demand for sterling (perhaps caused by a rise in exports or an increase in the speculative demand for sterling). This causes an appreciation in the value of the pound.
Changes in currency supply also have an effect. In the diagram below there is an increase in currency supply (S1-S2) which puts downward pressure on the market value of the exchange rate.
A currency can operate under one of four main types of exchange rate system sys tem FREE FLOATING FLOATING
Value of the currency is determined solely by market demand for and supply of the currency in the foreign exchange market. Trade flows and capital flows are the main factors affecting the t he exchange rate In the long run it is the macro economic performance of the economy (including trends in competitiveness) that drives the value of the currency No pre-determined official target for the exchange rate is set by the Government. The government and/or monetary authorities can set interest rates for domestic economic purposes rather than to achieve a given exchange rate target
It is rare for pure free floating exchange rates to exist - most governments at one time or another seek to "manage" the value of their currency through changes in interest rates and other controls UK sterling has floated on the foreign exchange markets since the UK suspended membership of the ERM in September 1992
MANAGED FLOATING EXCHANGE RATES RATES
Value of the pound determined by market demand for and supply of the currency with no predetermined target for the exchange rate is set by the Government Governments normally engage in managed floating if not part of a fixed exchange rate system. syste m. Policy pursued from 1973-90 and since the ERM suspension suspen sion from 1993-1998
SEMI-FIXED EXCHANGE RATES RATES
Exchange rate is given a specific target Currency can move between permitted bands of fluctuation Exchange rate is dominant target of economic policy-making (interest rates are set to meet the target) Bank of England may have to intervene to maintain the value of the currency within the set targets Re-valuations possible but seen as last resort October 1990 - September 1992 during period of ERM membership
FULLY-FIXED EXCHANGE RATES RATES
Commitment to a single fixed exchange rate No permitted fluctuations from the central rate Achieves exchange rate stability but perhaps at the expense of domestic economic stability Bretton-Woods System 1944-1972 where currencies were tied to the US dollar Gold Standard in the inter-war years - currencies linked with gold Countries joining EMU in 1999 have fixed their exchange rates until the year y ear 2002
Advantages of floating exchange rates rates Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. If an economy has a large deficit, there is a net outflow of currency from the country. This puts downward pressure on the exchange rate and if a depreciation occurs, the relative price of exports in overseas markets falls (making exports more competitive) whilst the relative price of imports in the home markets goes up (making imports appear a ppear more expensive). This should help reduce the overall deficit in the balance of trade provided that the price elasticity of demand for exports and the price elasticity of demand for imports is sufficiently high. A second key advantage of floating exchange rates is that it gives the government / monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be set to keep the value of the exchange rate within pre-determined bands. For example when the UK came out of the Exchange Rate Mechanism in September 1992, this allowed a sharp cut in interest rates which helped to drag the economy out of a prolonged recession.
Advantages of Fixed Exchange Rates (disadvantages of floating rates) Fixed rates provide greater certainty for exporters and importers and under normally circumstances there is less speculative activity - although this depends on whether the dealers in the foreign exchange markets regard a given fixed exchange rate as appropriate and credible. Sterling came under intensive speculative attack in the autumn of 1992 because the markets perceived it to be overvalued and ripe for a devaluation. Fixed exchange rates can exert a strong discipline on domestic firms and employees to keep their costs under control in order- which to remain in international markets. Thisand helps the government maintain low inflation in thecompetitive long run should bring interest rates down stimulate increased trade and investment.