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III - Fixed & Floating Rates

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Fixed Exchange Rates vs. Floating Exchange Rates


Exchange Rate Regimes

What are fixed Exchange Rates?

- Officials commit to maintaining the exchange rate at a specific level.


Exchange Rate Regimes What are Floating Exchange Rates?

- No intervention from bankers or government officials. The market determines the price of the currency.


Exchange Rate Regimes What is a “clean” float? A “dirty” one? 

- With a dirty float the government doesn’t  peg the currency, but but tries from time to time to influence the rate by buying or selling in the currency markets.


Fixed Exchange Rates 

How can the government keep a currency at a certain value if international commerce

 becomes unwilling to pay that price?  It can’t maintain the value for long. If the demand for the currency falls, it’s price would fall as well.


Fixed Exchange Rates 

The only way the price can be kept up is for the government promising to maintain the original level to enter the foreign exchange market and bid the price of the currency  back up by purchasing it.


Fixed Exchange Rates 

The government must buy the amount that will bring the quantity demanded  back to the original level.

$ Price of Franc

Supply of Francs

Demand for Francs Quantity of exchange


Fixed Exchange Rates

To what does the government fix the value of its currency?

When or how often does the country change the value of its fixed rate?


Fixed Exchange Rates 

How does the government defend the fixed value against any market pressures  pushing toward higher or lower exchange rate value?


Fix to what? 

In the past, all currencies were fixed to gold. Today, a country can fix its value to another country’s currency. 


Fix to what? 

A country can fix its currency to a “basket” of other currencies. -Same as diversifying a portfolio (Not putting all your eggs in one basket) -Special Drawing Right (SDR)…A basket of four major world currencies.


Defending a Fixed Exchange Rate 1.

To buy or sell foreign currencies (in order to influence the prevailing exchange rate), a government must have foreign exchange reserves.


It is not likely to have enough reserves to defend against a massive and sustained attack on the currency. What is an attack on a country’s currency? curr ency? (Answer: Massive “selling off” of a currency expected to be devalued. One can borrow the attacked currency and pay it back after devaluation.) 


Defending a Fixed Exchange Rate 

How can higher i rates keep the currency value up? (Answer: Foreigners will purchase the nation’s currency, bidding its value upward, to make short-term investments in the country.) 


Defending a Fixed Exchange Rate


The government can also make long-term adjustments of its macroeconomic (monetary and/or fiscal policy). Budget austerity avoids inflation and takes downward pressure off currency.


Defending a Fixed Exchange Rate


Why does inflation put downward  pressure on a country’s exchange rate?  Non-inflating countries are are unwilling to pay pay more and more to buy an inflating country’s goods and services. Reduced demand for the inflating currency will make it depreciate.


Defending a Fixed Exchange Rate


Why does inflation put downward  pressure on a country’s exchange rate?

Citizens of the inflating country will want to seek  bargains through imports, imports, selling their currency to obtain other currencies. Selling increases the supply and drives the price down further.


Defending The Peso Under Attack

Assume the Peso has been inflating in Mexico Downward pressure will be on the peso. (Less demand for it, since fewer will be  purchased with Mexican Mexican prices going up.) up.)


Defending The Peso Under Attack


The Mexican government intervenes in currency markets, purchasing pesos to maintain their value and promises it will never  permit  permit its value to fall.


Defending The Peso Under Attack 4.

The attack will be under way if people don’t believe the promise. People sell their  pesos forNote: dollars, etc., money while the while price is still up. borrow in Mexico, change it quickly for dollars. Pay back the loan later with cheap pesos.


Defending The Peso Under Attack


The Mexican government soon runs out of


reserves and lets the peso price fall. People purchase pesos back at the new, lower rate for good gains.


When to Change the Rate? 

Why might a government want to change the exchange value of its currency? It might do so in order to promote, for example, greater export volume.


When to Change the Rate? 

What is a pegged exchange rate?

The term pegged exchange rate refers to setting a targeted value for a country’s foreign exchange, and it indicates the govt. has some s ome ability to move the peg.


When to Change the Rate? 

Governments attempt to keep the value fixed for relatively long periods of time to reduce trade uncertainties.

What is an adjustable peg ? The government may change the pegged rate if a substantial disequilibrium in the country’s

international position develops (e.g., demand for the currency is too weak to maintain the desired value).


When to Change the Rate? 

A crawling peg can be changed c hanged often (monthly, say) according to a set of indicators or the

 judgment of the country’s monetary authority.   Indicators:  –  The difference of inflation rates  –  International reserve assets  –  Growth of the money supply  –  The current actual market exchange rate relative

to the central par value of the pegged rate


The Floating Exchange Rate 

Clean Float • Supply and Demand are solely private activities • Complete flexibility


The Floating Exchange Rate 

Dirty Float (Managed Float) to time, the government • From tries totime impact the rate through intervention

• More popular than clean float • Effectiveness of intervention is controversial


Monetary Policy with Fixed Exchange Rates Expanding the Money Supply Worsens Worsens the Balance of Payments Capital flows out.

(in the short run) To improve a poor macroeconomic situation, a country increases its money supply so that banks are more willing to lend.

The overall

Interest rate drops

payments balance “worsens.”   “worsens.”

Real spending, production, and income rise, but The price level increases.

The Current account balance “worsens” as exports fall and imports increase.


Monetary Policy with Floating Exchange Rates Effects of Expanding the Money Supply Capital flows out.

(In the short run) With an increase in the money supply supply,, banks are more willing to lend.


Interest rate drops

depreciation and automatic adjustment begins!

Real spending, production, and income rise.

Current account .”   balance “worsens.”

The Price level increases.

(Beyond the short run)

The Current account balance improves

Real product and income rise more


In Conclusion

Fixed exchange rates are government governmen t controlled. Floating exchange rates are market driven.


In Conclusion 

Governments have always preferred the improved business climate of fixed rates  – They reduce the uncertainty of unstable currency values (note the European Monetary System’s fixed rates of the 1990s).


In Conclusion 

But as financial markets have developed to accommodate for flexible exchange rates,come moreto and more the countries have appreciate value of market determination.


Readings Addendum 

The reading by Peter b. Kenen, “fixed versus Floating Exchange Rates” isof  probably expressive of a majority economists.

Once, during era of the Bretton System, manythe feared floating rates.Woods Their uncertainty would hinder international trade


Kenen on Fixed and Floating Rates 

Times have changed since the early 1970s and Nixon’s Woods. Markets havedestruction developed of to Bretton hedge exchange risks and we have become accustomed to the uncertainties associated with them. Trade flourishes.


Kenen on Fixed and Floating Rates 

Fixing the exchange rate deprives a government very valuable instruments, of thetwo nominal exchangepolicy rate and monetary policy, and it may therefore be tempted to adopt beggar-thy-neighbo be ggar-thy-neighborr trade  policies to cope with output-reducing shocks.


Kenen on Fixed and Floating Rates 

Fixing the exchange rate may help stabilize ainflation. country trade that has suffered extensively with policies to cope with outputreducing shocks.

The commitment to a pegged exchange rate is implicitly a commitment to monetary and fiscal stability, without which a fixed rate cannot survive. Pegging can buy credibility.


Kenen on Fixed and Floating Rates 

When asymmetric economic shocks trouble nations, some cannot cope withoutwise changing their exchange rates. “It is neither nor realistic to advocate world-wide pegging.” 


Richard N. Cooper on Exchange Rate Choices 

Many countries have gone to the float for their exchange rates, but many still decide to peg their currency or fix their exchange rate. The choice is probably the most important macro-economic policy decision a country makes.


Richard N. Cooper on Exchange Rate Choices 

Cooper reviews the international monetary experience among the major countries, reviewing the reasons why floating rates were long viewed with suspicion.

He discusses the Friedman/Johnson case for flexible rates made in the sixties and seventies. Johnson thought the developing countries would continue to peg their rates.


Richard N. Cooper on Exchange Rate Choices 

Cooper reviews the potential pitfalls for developing countries when international institutions insist that they both move to greater exchange rate flexibility and to liberalize international capital movements at the same time.


Richard N. Cooper on Exchange Rate Choices 

Flexible exchange rates have worked very well for the leading industrial countries. It will be interesting to see how Europe fares with absolutely fixed exchange rates among EU members (viarelationship the Euro) and how the Euro/U.S. Dollar develops.


Richard N. Cooper on Exchange Rate Choices 

We’re still learning, but movements in

exchange rates provide a useful shock absorber for real disturbances to the world economy, but they are also a significant source of uncertainty for trade and capital formation, the wellsprings of economic  process.

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