III.fixed & Floating Rates

7/26/2019 III.fixed & Floating Rates

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Fixed Exchange Rates

vs.

Floating Exchange Rates


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Exchange Rate Regimes

What are fixed Exchange Rates?

- Officials commit to maintaining theexchange rate at a specific level.


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What are Floating Exchange Rates?

- No intervention from bankers or

government officials. The market

determines the price of the currency.


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What is a clean float? A dirty one?

- With a dirty float the government doesntpeg the currency, but tries from time to time

to influence the rate by buying or selling in

the currency markets.


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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.


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The only way the price can be kept up is for

the government promising to maintain the

original level to enter the foreign exchangemarket and bid the price of the currency

back up by purchasing it.


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The government must buy the amountthat will bring the quantity demandedback to the original level.

Quantity of exchange

$ Price of FrancSupply of Francs

Demand for Francs


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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?


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How does the government defend the fixed

value against any market pressures

pushing toward higher or lower exchange

rate value?


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Fix to what?

In the past, all currencies were fixed togold.

Today, a country can fix its value toanother countrys currency.


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Fix to what?

A country can fix its currency to abasket of other currencies.

-Same as diversifying a portfolio (Notputting all your eggs in one basket)

-Special Drawing Right (SDR)A basket offour major world currencies.


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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 defendagainst 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 theattacked currency and pay it back after devaluation.)


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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.)


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3. 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.


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3. Why does inflation put downward

pressure on a countrys exchange rate?

Non-inflating countries are unwilling to pay moreand more to buy an inflating countrys goods and

services. Reduced demand for the inflating currency

will make it depreciate.


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3. 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.


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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 bepurchased with Mexican prices going up.)


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1. The Mexican government intervenes in

currency markets, purchasing pesos to

maintain their value and promises it will

neverpermit its value to fall.


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4. 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.


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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.


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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.


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What is a pegged exchange rate?

The termpegged exchange raterefers to setting

a targeted value for a countrys foreignexchange, and it indicates the govt. has some

ability to move the peg.


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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 desiredvalue).


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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


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The Floating Exchange Rate

Clean Float Supply and Demand are solely

private activities

Complete flexibility


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The Floating Exchange Rate

Dirty Float (Managed Float)

From time to time, the government

tries to impact the rate throughintervention

More popular than clean float

Effectiveness of intervention iscontroversial


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To improve a poor

macroeconomic

situation, acountry 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 importsincrease.

The overall

payments balance

worsens.

The price level

increases.

Expanding the Money Supply Worsens the Balance of Payments

Monetary Policy with Fixed Exchange Rates

M t P li ith Fl ti E h R t


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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

automaticadjustment begins!

The Price level

increases.

Effects of Expandingthe Money Supply

The

Current

account

balance

improves

Real

product

and

income

rise more

(Beyond the short run)

Monetary Policy with Floating Exchange Rates


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In Conclusion

Fixed exchange rates are

government controlled.

Floating exchange rates are market

driven.


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In Conclusion

Governments have always preferredthe improved business climate of fixed

rates

They reduce the uncertainty ofunstable currency values (note the

European Monetary Systems fixed

rates of the 1990s).


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In Conclusion

But as financial markets havedeveloped to accommodate for flexible

exchange rates, more and more

countries have come to appreciate thevalue of market determination.


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Readings Addendum

The reading by Peter b. Kenen, fixed

versus Floating Exchange Rates is

probably expressive of a majority ofeconomists.

Once, during the era of the Bretton Woods

System, many feared floating rates. Theiruncertainty would hinder international trade


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Kenen on Fixed and Floating Rates

Times have changed since the early 1970s

and Nixons destruction of Bretton Woods.

Markets have developed to hedge exchangerisks and we have become accustomed to

the uncertainties associated with them.

Trade flourishes.


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Fixing the exchange rate deprives a

government of two very valuable policy

instruments, the nominal exchange rate andmonetary policy, and it may therefore be

tempted to adopt beggar-thy-neighbor trade

policies to cope with output-reducingshocks.


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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 andfiscal stability, without which a fixed rate

cannot survive. Pegging can buy credibility.


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When asymmetric economic shocks trouble

nations, some cannot cope without changing

their exchange rates. It is neither wise norrealistic to advocate world-wide pegging.


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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 exchangerate. The choice is probably the most

important macro-economic policy decision

a country makes.


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Cooper reviews the international monetary

experience among the major countries,

reviewing the reasons why floating rateswere long viewed with suspicion.

He discusses the Friedman/Johnson case for

flexible rates made in the sixties andseventies. Johnson thought the developing

countries would continue to peg their rates.


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Cooper reviews the potential pitfalls for

developing countries when international

institutions insist that they both move togreater exchange rate flexibility and to

liberalize international capital movements at

the same time.

Ri h d N C


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Flexible exchange rates have worked very

well for the leading industrial countries. It

will be interesting to see how Europe fareswith absolutely fixed exchange rates among

EU members (via the Euro) and how the

Euro/U.S. Dollar relationship develops.

Ri h d N C


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Were still learning, but movements in

exchange rates provide a useful shock

absorber for real disturbances to the worldeconomy, but they are also a significant

source of uncertainty for trade and capital

formation, the wellsprings of economicprocess.

Documents

III.fixed & Floating Rates