Floating exchange rates Countries can choose the exchange rate system

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					Floating exchange rates Countries can choose the exchange rate system they operate with – the main options are: (1) Free-floating exchange rate (2) Managed floating system (3) Semi-fixed exchange rate system (4) Fully-fixed exchange rate system (5) Monetary Union with other countries Since 1992 the UK has operated with a floating exchange rate – the external value of the currency has been left to market forces i.e. the supply and demand for sterling in the global foreign exchange markets. In a pure floating system, there is official target for the exchange rate and there is no need for intervention in the currency market by the central bank.
United Kingdom Effective Exchange Rate Index
Trade-weighted index value for sterling in the foreign exchange market, daily value
110
110

The economic arguments for a floating exchange rate 1. Less need to hold huge foreign currency reserves for use in FX market intervention 2. Floating currencies can be a useful instrument of macroeconomic adjustment e.g. a lower currency can stimulate aggregate demand (a good example at the moment is the depreciation of sterling v the Euro)

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Index

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80 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

80

3. Provides partial “automatic correction” for a trade deficit e.g. a wide trade deficit should lead (cet par) to an excess supply of sterling leading to a lower currency (but beware of the possible ‘J curve effect’!) 4. Reduced risk of currency speculation – speculators often target fixed exchange rates that they feel are over or under-valued 5. Freedom (autonomy) for domestic monetary policy - allows countries greater freedom to set interest rates for domestic economic aims such as inflation control / maintaining economic growth 6. Floating exchange rates don’t always have to be volatile – consider the chart above which shows the sterling trade-weighted index – which was remarkably stable from 1997 to 2006. Risks with floating exchange rates 1. Danger that the currency is volatile which may harm international trade and capital investment – one of the arguments either for s semi-fixed system or perhaps joining a currency union 2. Fluctuating currencies increases the need for hedging costs by exporters and importers

3. Fixed exchange rate provides a discipline on domestic producers to keep costs & prices down – may be
less significant if the currency moves up and down – if businesses know that the currency might fall to provide them with a competitive boost, they might be less likely to pursue productivity gains.

UK Trade and the Exchange Rate
Monthly balance of trade in goods and services (seasonally adjusted) and exchange rate index
0.0 -0.5 -1.0 GBP (billions) -1.5 -2.0 -2.5 -3.0 -3.5 -4.0 -4.5 -5.0 106 Effective ex rate index (millions) 104 102 100 98 96 94 00 01 02 03 04 05 06 07 08 UK Trade Balance £bn 0.0 -0.5 -1.0 -1.5 -2.5 -3.0 -3.5 -4.0 -4.5 -5.0 106 104 102 100 98 96 94 millions billions -2.0

Source: Reuters EcoWin

United States Balance of Trade in Goods
$ billion per month
130 125 120 Index 115 110 105 100 95 0 -10 USD (billions) -20 -30 -40 -50 -60 -70 00 01 02 03 04 05 06 07 08 130 125 120 115 110 105 100 95 0 -10 -20 billions -30 -40 -50 -60 -70

Federal Reserve, Trade Weighted Exchange Index Broad Trade Balance, Total, Goods and services, SA Source: Reuters EcoWin

The key argument

Countries have always faced constraints in choosing their exchange rate regime. Any country can have only two out of the following three: 1. An independent monetary policy (freedom to set interest rates) 2. A fixed exchange rate (currency stability and predictability) 3. An open capital account (freedom to finance a current account deficit) As international financial markets have developed, there has been a general movement to flexible exchange rates supported by credible domestic monetary policies. That is a sensible use of the price mechanism to respond to complex and unpredictable shocks. The floating exchange rate system has suited the UK well – we are an open economy with a large current account deficit and need the flexibility that a market determined currency provides