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 tries from time to time to influence the rate by buying or selling in the currency markets.

Fixed Exchange Rates l How can the government keep a currency at a certain value if international commerce becomes unwilling to pay that price? l 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 l 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 l The government must buy the amount that will bring the quantity demanded back to the original level. Quantity of exchange $ Price of Franc Supply of Francs Demand for Francs

Fixed Exchange Rates l To what does the government fix the value of its currency? l When or how often does the country change the value of its fixed rate?

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

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

Fix to what? l 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. 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 “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 in the Exchange Markets: the Interest Rates  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 by changing the “fundamentals” 3. Long-term adjustments of its macroeconomic (monetary and/or fiscal) policy. Budget austerity avoids inflation and takes downward pressure off currency.

Inflation Puts Downward Pressure On the Exchange Rate  THE DEMAND SIDE:  Non-inflating countries are unwilling to pay more and more to buy an inflating country’s goods and services. Reduced demand for the inflating currency will make it depreciate.

Inflation Puts Downward Pressure On the Exchange Rate SUPPLY SIDE:  Citizens of the inflating country will want to seek bargains through imports, selling their currency to obtain other currencies. Selling increases the supply and drives the price down further.

EXAMPLE: 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 prices going up.)

Defending The Peso Under Attack 1. The Mexican government intervenes in currency markets, purchasing pesos to maintain their value and promises it will never 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 for dollars, etc., while the price is still up. Note: borrow money 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 reserves and lets the peso price fall. 5. People purchase pesos back at the new, lower rate for good gains.

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

When to Change the Rate? l A pegged exchange rate sets a targeted value for a country’s foreign exchange, and the government can adjust the peg. l The government may use an adjustable peg. or a crawling peg. The rate may be changed if there is a substantial disequilibrium in the country’s international position (e.g., demand for the currency is too weak to maintain the desired value).

To improve a poor macroeconomic situation, a country increases its money supply so that banks are more willing to lend. Interest rate drops Real spending, production, and income rise, but Capital flows out. ( (in the short run) The Current account balance “worsens” as exports fall and imports increase. The overall payments balance “worsens.” The price level increases. Expanding the Money Supply Worsens the Balance of Payments Monetary Policy with Fixed Exchange Rates

With an increase in the money supply, banks are more willing to lend. Interest rate drops Real spending, production, and income rise. Capital flows out. (In the short run) Current account balance “worsens.” Currency depreciation and automatic adjustment begins! The Price level increases. Effects of Expanding the Money Supply Effects of Expanding the Money Supply The Current account balance improves Real product and income rise more (Beyond the short run) Monetary Policy with Floating Exchange Rates

In Conclusion l Fixed exchange rates are government controlled. l Floating exchange rates are market driven.

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