Fixed Exchange Rates vs. 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 gold. 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 up? (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 uncertainties. 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 value). 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 intervention • More popular than clean float • Effectiveness of intervention is controversial 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 drops 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 increase. The price level increases. 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 increases. (Beyond the short run) In Conclusion Fixed exchange rates are government controlled. Floating exchange rates are market driven. 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 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 economists. 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 shocks. 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 process.