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Fixed Exchange Rates vs. Floating Exchange Rates

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... for the currency falls, it's price would fall as well. Fixed Exchange Rates ... Why might a government want to change the exchange value of its currency? ... – PowerPoint PPT presentation

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Title: Fixed Exchange Rates vs. Floating Exchange Rates


1
Fixed Exchange Ratesvs.Floating Exchange Rates
Global Trade Finance Phil Bryson
2
Exchange Rate Regimes
  • What are fixed Exchange Rates?
  • - Officials commit to maintaining the exchange
    rate at a specific level.

3
Exchange Rate Regimes
  • What are Floating Exchange Rates?
  • - No intervention from bankers or government
    officials. The market determines the price of
    the currency.

4
Exchange Rate Regimes
  • What is a clean float? A dirty one?
  • - With a dirty float the government doesnt peg
    the currency, but tries from time to time to
    influence the rate by buying or selling in the
    currency markets.

5
Fixed Exchange Rates
  • How can the government keep a currency at a
    certain value if international commerce becomes
    unwilling to pay that price?
  • It cant maintain the value for long. If the
    demand for the currency falls, its price would
    fall as well.

6
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.

7
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
8
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?

9
Fixed Exchange Rates
  • How does the government defend the fixed value
    against any market pressures pushing toward
    higher or lower exchange rate value?

10
Fix to what?
  • In the past, all currencies were fixed to gold.
  • Today, a country can fix its value to another
    countrys currency.

11
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.

12
Defending a Fixed Exchange Rate
  • 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 countrys
    currency?
  • (Answer Massive selling off of a currency
    expected to be devalued. One can borrow the
    attacked currency and pay it back after
    devaluation.)

13
Defending a Fixed Exchange Rate
  • How can higher i rates keep the currency value
    up?
  • (Answer Foreigners will purchase the nations
    currency, bidding its value upward, to make
    short-term investments in the country.)

14
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.

15
Defending a Fixed Exchange Rate
  • Why does inflation put downward pressure on a
    countrys exchange rate?
  • Non-inflating countries are unwilling to pay more
    and more to buy an inflating countrys goods and
    services. Reduced demand for the inflating
    currency will make it depreciate.

16
Defending a Fixed Exchange Rate
  • Why does inflation put downward pressure on a
    countrys exchange rate?
  • 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.

17
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.)

18
Defending The Peso Under Attack
  • The Mexican government intervenes in currency
    markets, purchasing pesos to maintain their value
    and promises it will never permit its value to
    fall.

19
Defending The Peso Under Attack
  • The attack will be under way if people dont
    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.

20
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.

21
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.

22
When to Change the Rate?
  • What is a pegged exchange rate?
  • The term pegged exchange rate refers to setting a
    targeted value for a countrys foreign exchange,
    and it indicates the govt. has some ability to
    move the peg.

23
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 countrys
    international position develops (e.g., demand for
    the currency is too weak to maintain the desired
    value).

24
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 countrys 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

25
The Floating Exchange Rate
  • Clean Float
  • Supply and Demand are solely private activities
  • Complete flexibility

26
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

27
Monetary Policy with Fixed Exchange Rates
Expanding the Money Supply 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 payments balance worsens.
Interest rate drops
The Current account balance worsens as exports
fall and imports increase.
Real spending, production, and income rise, but
The price level increases.
28
Monetary Policy with Floating Exchange Rates
Effects of Expanding the Money
Supply
Capital flows out.
(In the short run)
Currency depreciation and automatic adjustment
begins!
The Current account balance improves
Real product and income rise more
Interest rate drops
With an increase in the money supply, banks are
more willing to lend.
Real spending, production, and income rise.
Current account balance worsens.
The Price level increases.
(Beyond the short run)
29
In Conclusion
  • Fixed exchange rates are government controlled.
  • Floating exchange rates are market driven.

30
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 Systems fixed
    rates of the 1990s).

31
In Conclusion
  • 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.

32
Readings Addendum
  • The reading by Peter b. Kenen, fixed 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

33
Kenen on Fixed and Floating Rates
  • Times have changed since the early 1970s and
    Nixons destruction of Bretton Woods. Markets
    have developed to hedge exchange risks and we
    have become accustomed to the uncertainties
    associated with them. Trade flourishes.

34
Kenen on Fixed and Floating Rates
  • Fixing the exchange rate deprives a government of
    two very valuable policy instruments, the nominal
    exchange rate and monetary policy, and it may
    therefore be tempted to adopt beggar-thy-neighbor
    trade policies to cope with output-reducing
    shocks.

35
Kenen on Fixed and Floating Rates
  • Fixing the exchange rate may help stabilize a
    country that has suffered extensively with
    inflation. trade policies to cope with
    output-reducing 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.

36
Kenen on Fixed and Floating Rates
  • When asymmetric economic shocks trouble nations,
    some cannot cope without changing their exchange
    rates. It is neither wise nor realistic to
    advocate world-wide pegging.

37
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.

38
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.

39
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.

40
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
    (via the Euro) and how the Euro/U.S. Dollar
    relationship develops.

41
Richard N. Cooper on Exchange Rate Choices
  • Were 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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