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Fixed Exchange Rate System Vs Floating Exchange Rate System Group 6History1821-1914 most of the World's currencies were redeemable into gold. (i.e. you could "cash in" your paper notes for predefined weights of gold coin).Britain was the first to officially adopt this system in 1821 and was followed by other key countries during 1870s.The result was a global economy connected by the common use of gold as money.The Bretton Woods Agreement founded a system of fixedexchangeratesin which the currencies of all countries were pegged to the US dollar, which in turn was based on the gold standard.By 1970, the existingexchangerate systemwas already under threat. The Nixon-led US government suspended the convertibility of the national currency into gold. The supply of the US dollar had exceeded its demand. In 1971, the Smithsonian Agreement was signed. For the first time in exchange rate history, the market forces of supply and demand began to determine the exchange rate.

categories of exchange rate System

Flexible Exchange Rate SystemsFixed Exchange-rate SystemMonetary Unions

Flexible Exchange Rate SystemsThe value of the currency is determined by the market (banks, firms and other institutions) Higher demand for a currency, all else equal, leads to an appreciation of the currency while a decrease in demand will lead to depreciation.Increase in the supply of a currency, all else equal, will lead to a depreciation of that currency while a decrease in supply, all else equal, will lead to an appreciation.Most OECD countries have flexible exchange rate systems: the U.S., Canada, Australia, Britain, and the European Monetary Union.Managed Floating

Afloating exchange ratein which a government intervenes at some frequency to change the direction of the float bybuyingorselling currencies.

The central bank does not have an explicit set value, it doesnt allow the market to freely determine the value of the currency.

The problems of Flexible exchange rate systemThe exchange rate can move for many other reasons than changes in the domestic interest rate.

Expectations play a large role in the determination of the exchange rate.

Flexible exchange rate may be subject to large fluctuations which, in turn, require large movements in the interest rate which can make the economy unstable.

Exchange rate may overshoot for a long time

6Fixed Exchange-rate SystemA system whereby the exchange rates of the member countries were fixed against the U.S. dollar, with the dollar in turn worth a fixed amount of gold.Governments try to keep the value of their currencies constant against one another.A countrys government decides the worth of its currency in terms of either a fixed weight of gold, a fixed amount ofanother currencyor a basket of other currencies.Thecentral bankof a country remains committed at all times to buy and sell its currency at a fixed price.The central bank provides foreign currency needed to financepayments imbalances.How does it work?The government must buy the amount that will bring the quantity demanded back to the original level.

Quantity of exchange$ Price of FrancSupply of FrancsDemand for FrancsDe Facto Classification Exchange Rate Regimes and Monetary Policy Frameworks (IMF, 2008)

Exchange Arrangements with No Separate Legal TenderCurrency Board ArrangementsOther Conventional Fixed Peg ArrangementsPegged Exchange Rates within Horizontal BandsCrawling PegsExchange Rates within Crawling BandsManaged Floating with No Predetermined Path for the Exchange RateIndependently Floating

Exchange Arrangements with No Separate Legal TenderThe currency of another country circulates as the sole legal tender (formal dollarization)The member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union.It implies the complete surrender of the monetary authorities' independent control over domestic monetary policy Currency Board ArrangementsExchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation.Domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign assetsEliminates traditional central bank functions, such as monetary control and lender-of-last-resort, and leaving little scope for discretionary monetary policy.Some flexibility may still be afforded, depending on how strict the banking rules of the currency board arrangement.Other Conventional Fixed Peg ArrangementsCurrency is pegged at a fixed rate to another currency or a basket of currencies

The currency composites can also be standardized, as in the case of the Special Drawing Rights (a basket of four major world currencies)

The exchange rate may fluctuate within narrow margins of less than 1 percent around a central rate-or the maximum and minimum value of the exchange rate may remain within a narrow margin of 2 percent-for at least three months.

The monetary authority maintains the fixed parity through direct/indirect intervention sale/purchase of foreign exchange in the marketaggressive use of interest rate policyimposition of foreign exchange regulationsexercise of moral suasion that constrains foreign exchange activity

Pegged Exchange Rates within Horizontal BandsThe value of the currency is maintained within certain margins of fluctuation of at least 1 percent around a fixed central rate or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent.

There is a limited degree of monetary policy discretion, depending on the band width.Crawling PegsA 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 ratesInternational reserve assetsGrowth of the money supplyThe current actual market exchange rate relative to the central par value of the pegged rate

Exchange Rates within Crawling BandsThe currency is maintained within certain fluctuation margins of at least 1 percent around a central rate-or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent-and the central rate or margins are adjusted periodically at a fixed rate or in response to changes in selective quantitative indicators.The degree of exchange rate flexibility is a function of the band width. Bands are either symmetric around a crawling central parity or widen gradually with an asymmetric choice of the crawl of upper and lower bands (in the latter case, there may be no preannounced central rate). The commitment to maintain the exchange rate within the band imposes constraints on monetary policy, with the degree of policy independence being a function of the band width.Advantages and Disadvantages of Fixed exchange rate system AdvantageAvoid Currency FluctuationsStability encourages investmentKeep inflation low, joining a fixed exchange rate may cause inflationary expectations to be lowerA rapid appreciation in the exchange rate will badly effect manufacturing firms who export, this may also cause a worsening of the current account.

DisadvantageGiving up the powerful exchange rate tool for external stabilisation.

Sacrifice of domestic stability for external balance.

Gives up control of its interest rate, no independent monetary policy

Widespread speculation of a devaluation or shift to a flexible exchange rate system particularly whenEconomy is with higher inflationOr the currency is overvalued

Fear of Speculative attacks require an increase in the interest rate.

Frequent devaluation creates uncertainty and overvalued currency causes BOP problem.