1. Fixed and Floating Exchange Rates
A2 Economics
A2 Economics
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PowerPoint Briefings 2006

2. Exchange Rate Systems Countries can choose their exchange rate system:
(1) Free-floating exchange rate
(2) Managed floating system
(3) Semi-fixed exchange rate system
(4) Fully-fixed exchange rate system
(5) Monetary Union with other countries

3. The Sterling Exchange Rate Index

4. Floating Exchange Rates
The value of the currency is determined purely by market demand and supply of the currency
No target for the exchange rate is set by the Government
There is no need for official intervention in the currency market by the central bank
Sterling has floated freely on the foreign exchange markets since the UK suspended membership of the ERM in September 1992

5. Managed Floating Exchange Rate
Currency is usually determined by market forces
Some currency market intervention might be considered as part of demand management
Interest rates may be changed to affect the market value of the currency
No attempt is made to influence the long-term external value of the currency
There are limits to the effectiveness of intervention in markets

6. Semi-Fixed Exchange Rate
The exchange rate is given a specific target
The currency can move between permitted bands of fluctuation on a day-to-day basis
Exchange rate becomes an target of monetary policy-making (e.g. interest rates are set to meet the exchange rate target such as when the UK was in the ERM).
The central bank must intervene to maintain the value of the currency within the set targets if it moves outside the agreed range
Re-valuations of the currency are seen as a last resort or when intervention is proving ineffective

7. Fully-fixed exchange rate
Commitment to a fixed exchange rate
The exchange rate is pegged
There are no fluctuations from the agreed central rate
Examples?
This system achieves exchange rate stability but perhaps at the expense of domestic macro stability
A country can automatically improve its competitiveness by reducing its costs below that of other countries – knowing that the exchange rate will remain stable

8. China and the US dollar
China has been criticized by those who say its fixed-rate monetary policy boosts exports by keeping the yuan at a low level.

9. Currency Boards
Currency board: a country commits, by law, to exchange domestic currency for a specified foreign currency at a fixed rate.
Example:
Argentina adopted currency board between when one peso can be exchanged to one dollar.
To maintain the currency board arrangement, the constitution of Argentina specifies that the amount of domestic money supply cannot exceed the country’s foreign reserves.

10. Currency boards - Argentina

11. UK Economic History
: UK operated with a managed floating exchange rate. There was some intervention by the central bank to influence the exchange rate and government was in control of interest rates
October September 1992: UK a member of the European exchange rate mechanism (ERM) – the exchange rate was a specific target of economic policy
September 1992 – present day: the UK has operated with a free-floating exchange rate – no intervention by the Bank of England. Exchange rate is purely market determined
Since 1999, the Euro has been in existence as twelve nations have established a single currency. Sterling floats freely against the Euro and also against the dollar, yen etc.

12. The ERM experiment Britain entered the ERM in October 1990
The main aims were to
(i) Achieve exchange rate stability to promote trade
(ii) Provide an anchor for Monetary policy in order to bring down inflation – the UK was fixing sterling against the low-inflation German economy
Under the ERM UK interest rates had to be set at a level consistent with keeping sterling at agreed levels (DM 2.95)
But the weakness of the British economy (recession, rising unemployment and a housing recession) meant that interest rates were probably too high for our own needs
Inflation came down but sterling was weak
The speculators attacked!

13. Coming out of the ERM – Sept 1992

14. Counting the cost of leaving the ERM
Treasury notes – published in February 2005(!)
On Black Wednesday itself, September 16, 1992, the Bank of England sold some $28 billion of official foreign reserves trying to keep sterling within its ERM target range
This intervention failed and sterling was forced out of the ERM and allowed to float freely
Advantages:
A lower pound boosted the competitiveness of exporters
Interest rates could now come down in order to provide a boost to aggregate demand and take the British economy out of recession
Fears of rising inflation proved unfounded – there was plenty of spare capacity in the British economy at the time

15. Evaluating exchange rate systems
Fixed versus floating rates

16. King on exchange rate regimes
Countries have always faced constraints in choosing their exchange rate regime.
Any country can have only two out of the following three:
an independent monetary policy
a fixed exchange rate
an open capital account.
As international financial markets have developed, there has been a general movement to flexible exchange rates supported by credible domestic monetary policies. That is a sensible use of the price mechanism to respond to complex and unpredictable shocks.

17. The Case for Floating Rates
Less need for currency reserves for use in intervention
Useful instrument of macroeconomic adjustment e.g. a lower currency can stimulate aggregate demand
Provides partial “automatic correction” for a trade deficit
Reduced risk of currency speculation
Freedom (autonomy) for domestic monetary policy
Floating exchange rates are not always volatile exchange rates!

18. The Case for Fixed Exchange Rates
Stability - helpful for trade and capital investment
Some flexibility (i.e. the occasional devaluation or revaluation of the currency – known as “realignment”)
Reductions in costs of currency hedging for businesses
Fixed rate provides a discipline on domestic producers to keep costs and prices down and to raise productivity
Reinforces gains in comparative advantage:
If one country has a fixed rate with another, then differences in relative costs will quite easily be reflected in changes in the rate of growth of exports and imports

19. Dollar-Rouble