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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?

- Offi Officials cials com commit mit to main maintaining taining the exchange rate at a specific level.

 

Exchange Rate Regimes What are Floating Exchange Rates?

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

 

Exchange Rate Regimes What

is a ³clean´ float? A ³dirty´ ³dirty ´ one?

- With a dirty float the government doesn¶t  peg the currency, but tries from time to time to influence the rate by buying or selling in the currency markets.

 

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 ³basket´ 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 se ll foreign currencies (in order to influence the prevailing exchange rate), a government must have foreign exchange reserves.

2.

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? (Answer: Massive ³selling off´ of a currency currenc y expected to be devalued. One can borrow the attacked currency and pay it back after a fter 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 investments in the country.)

 

Defending a Fixed Exchange Rate

3.

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

 

Defending a Fixed Exchange Rate

3.



Why

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

 

Defending a Fixed Exchange Rate

3.

Why

does inflation put downward

 pressure on a country¶s country¶s exchange rate? 

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

 

Defending

The Peso Under Attack

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

 

Defending

1.

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

4.

The Peso Under Attack

The attack will be under way if people don¶t believe the promise. People sell their   pesos forNote: dollars, etc., money while the 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

4.

The Mexican government soon runs out of 

5.

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

 

What

to Change the Rate?

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 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 often (monthly, say) according to a set of indicators or the

 judgment of the country¶s monetary authority.  Indicators:  ± The diff differe erence nce of infl inflati ation on rates rates  ± Int Interna ernatio tional nal rese reserve rve asset assetss  ± Grow Growth th of the the money money suppl supply y  ± The current current actual actual market exchang exchangee rate rate relative relative to the central par value of the pegged peg ged rate

 

The Floating Exchange Rate 

Clean

Float ‡ Supply

and Demand are solely private activities

‡ Complete flexibility

 

The Floating Exchange Rate 

Dirty Float (Managed Float) ‡

From time to time, the government tries to impact the rate through intervention ‡

More popular than clean float

‡

Effectiveness of intervention is controversial

 

Monetary Policy with Fixed Exchange Rates S

Expanding the Money upply Worsens Worsens the Balance of o f Payments Capital

flows out.

(in the short run) (in To

improve a poor

macroeconomic situation, a country increases its money supply so that banks are more willing to lend.

The

overall payments balance ³worsens.´

Interest rate drops

Real spending, production, and income rise, but The

price level increases.

The Current

account

balance ³worsens´ 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, banks are more willing to lend.

Interest rate drops

Real spending, production, and income rise.

Currency

The

depreciation and automatic adjustment begins!

Current

Current

account balance ³worsens.´

The

Price level increases.

(Beyond (Beyo nd the short run)

account balance improves

Real product and income rise more

 

In





Conclusion

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

 

In 

Conclusion

Governments have always preferred the improved business climate of fixed rates  ± They reduce reduce the the uncertainty 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 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, ³fixed versus Floating Exchange Rates´ is  probably expressive of a majority of  economists.



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

 

Kenen



on Fixed and Floating Rates

Times have changed since the early 1970s W

and Nixon¶s oods. 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 of two very valuable policy instruments,, the nominal exchange rate and instruments monetary policy, and it may therefore be tempted to adopt beggar-thy-neighbor 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 commitment to t o 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



When

on Fixed and Floating Rates

asymmetric economic shocks trouble asymmetric

nations, some cannot cope withoutwise changing their exchange rates. ³It 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 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.



H

e discusses Friedman/Johnson flexible rates the made in the sixties andcase for  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 members (via the Euro) and how the Euro/U.S. Dollar relationship develops.

 

Richard N. Cooper on Exchange Rate Choices 

We¶re

still learning, but movements 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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