Fixed Exchange Rate

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					 Fixed Exchange Rates
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

   How can the government keep a currency
    at a certain value if international commerce
    becomes unwilling to pay that price?
   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

   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

              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
          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?
          Fixed Exchange Rates

   How does the government defend the fixed
    value against any market pressures
    pushing toward higher or lower exchange
    rate value?
              Fix to what?

 In the past, all currencies were fixed to
 Today, a country can fix its value to
  another country’s currency.
                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.
     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

   How can higher i rates keep the currency value
   (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

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.
     Defending a Fixed Exchange Rate

3.    Why does inflation put downward
      pressure on a country’s exchange rate?
     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.
     Defending a Fixed Exchange Rate

3.    Why does inflation put downward
      pressure on a country’s 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.
 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?

   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.
         When to Change the Rate?

   What is a pegged exchange rate?
   The term pegged exchange rate refers to setting
    a targeted value for a country’s foreign
    exchange, and it indicates the govt. has some
    ability to move the peg.
         When to Change the Rate?
   Governments attempt to keep the value fixed for
    relatively long periods of time to reduce trade
   What is an adjustable peg?
   The government may change the pegged rate if a
    substantial disequilibrium in the country’s
    international position develops (e.g., demand for
    the currency is too weak to maintain the desired
           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 country’s 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
The Floating Exchange Rate

   Clean Float
            • Supply and Demand are solely
              private activities
            • Complete flexibility
    The Floating Exchange Rate
   Dirty Float (Managed Float)
            • From time to time, the government
              tries to impact the rate through
            • More popular than clean float
            • Effectiveness of intervention is
              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                                                The overall
                    Interest rate
macroeconomic                                                    payments balance
situation, a                                                     “worsens.”
country increases
its money supply
so that banks are
more willing to                                            The Current account
                             Real spending,
lend.                                                      balance “worsens” as
                             production, and
                                                           exports fall and imports
                             income rise, but

                                    The price level
        Monetary Policy with Floating Exchange Rates

              Effects of Expanding the Money Supply

                                Capital flows out.
                                (In the short run)

                                             Currency             The        Real
With an           Interest
                                             depreciation and     Current    product
increase in the   rate
                                             automatic            account    and
money supply,     drops
                                             adjustment begins!   balance    income
banks are
more willing                                                      improves   rise more
to lend.
                    Real spending,           Current account
                    production, and          balance “worsens.”
                    income rise.

                               The Price level
                               (Beyond the short run)
          In Conclusion

 Fixed exchange rates are
  government controlled.
 Floating exchange rates are market
             In Conclusion
   Governments have always preferred
    the improved business climate of fixed
     – They reduce the uncertainty of
       unstable currency values (note the
       European Monetary System’s fixed
       rates of the 1990s).
             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.
         Readings Addendum
   The reading by Peter b. Kenen, “fixed
    versus Floating Exchange Rates” is
    probably expressive of a majority of
   Once, during the era of the Bretton Woods
    System, many feared floating rates. Their
    uncertainty would hinder international trade
Kenen on Fixed and Floating Rates

   Times have changed since the early 1970s
    and Nixon’s destruction of Bretton Woods.
    Markets have developed to hedge exchange
    risks and we have become accustomed to
    the uncertainties associated with them.
    Trade flourishes.
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
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.
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.”
         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.
         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.
          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.
          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.
          Richard N. Cooper on
         Exchange Rate Choices

   We’re 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