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Float
A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime
wherein a currency's value is allowed to fluctuate according to the foreign exchange
market. A currency that uses a floating exchange rate is known as a floating currency. It
is not possible for a developing country to maintain the stability in the rate of exchange
for its currency in the exchange market.
There are economists who think that, in most circumstances, floating exchange rates are
preferable to fixed exchange rates. As floating exchange rates automatically adjust, they
enable a country to dampen the impact of shocks and foreign business cycles, and to
preempt the possibility of having a balance of payments crisis. However, in certain
situations, fixed exchange rates may be preferable for their greater stability and certainty.
This may not necessarily be true, considering the results of countries that attempt to keep
the prices of their currency "strong" or "high" relative to others, such as the UK or the
Southeast Asia countries before the Asian currency crisis. The debate of making a choice
between fixed and floating exchange rate regimes is set forth by the Mundell-Fleming
model, which argues that an economy cannot simultaneously maintain a fixed exchange
rate, free capital movement, and an independent monetary policy. It can choose any two
for control, and leave third to the market forces.
In cases of extreme appreciation or depreciation, a central bank will normally intervene to
stabilize the currency. Thus, the exchange rate regimes of floating currencies may more
technically be known as a managed float. A central bank might, for instance, allow a
currency price to float freely between an upper and lower bound, a price "ceiling" and
"floor". Management by the central bank may take the form of buying or selling large lots
in order to provide price support or resistance, or, in the case of some national currencies,
there may be legal penalties for trading outside these bounds.
Fear of floating
A free floating exchange rate increases foreign exchange volatility. There are economists
who think that this could cause serious problems, especially in emerging economies.
These economies have a financial sector with one or more of following conditions:
high liability dollarization
financial fragility
strong balance sheet effects
When liabilities are denominated in foreign currencies while assets are in the local
currency, unexpected depreciations of the exchange rate deteriorate bank and corporate
balance sheets and threaten the stability of the domestic financial system.
For this reason emerging countries appear to face greater fear of floating, as they have
much smaller variations of the nominal exchange rate, yet face bigger shocks and interest
rate and reserve movements.[1] This is the consequence of frequent free floating countries'
reaction to exchange rate movements with monetary policy and/or intervention in the
foreign exchange market.
The number of countries that present fear of floating increased significantly during the
nineties.[2]
Pegged float
Here, the currency is pegged to some band or value, either fixed or periodically adjusted.
Pegged floats are:
Crawling bands: the rate is allowed to fluctuate in a band around a central value,
which is adjusted periodically. This is done at a preannounced rate or in a
controlled way following economic indicators.
Crawling pegs: Here, the rate itself is fixed, and adjusted as above.
Pegged with horizontal bands: The currency is allowed to fluctuate in a fixed
band (bigger than 1%) around a central rate.
Fixed
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange
rate regime wherein a currency's value is matched to the value of another single currency
or to a basket of other currencies, or to another measure of value, such as gold.
A fixed exchange rate is usually used to stabilize the value of a currency against the
currency it is pegged to. This makes trade and investments between the two countries
easier and more predictable, and is especially useful for small economies where external
trade forms a large part of their GDP.
It can also be used as a means to control inflation. However, as the reference value rises
and falls, so does the currency pegged to it. In addition, according to the Mundell-
Fleming model, with perfect capital mobility, a fixed exchange rate prevents a
government from using domestic monetary policy in order to achieve macroeconomic
stability.
There are no major economic players that use a fixed exchange rate (except the countries
using the Euro and the Chinese Yuan). The currencies of the countries that now use the
euro are still existing (e.g. for old bonds). The rates of these currencies are fixed with
respect to the euro and to each other. The most recent such country to discontinue their
fixed exchange rate was the People's Republic of China[citation needed], which did so in July
2005.[1] However, as of September 2010, the fixed-exchange rate of the Chinese Yuan has
only increased 1.5% in the last 3 months.[ 2 ]
Maintenance
Typically, a government wanting to maintain a fixed exchange rate does so by either
buying or selling its own currency on the open market. This is one reason governments
maintain reserves of foreign currencies. If the exchange rate drifts too far below the
desired rate, the government buys its own currency in the market using its reserves. This
places greater demand on the market and pushes up the price of the currency. If the
exchange rate drifts too far above the desired rate, the government sells its own currency,
thus increasing its foreign reserves.
Another, less used means of maintaining a fixed exchange rate is by simply making it
illegal to trade currency at any other rate. This is difficult to enforce and often leads to a
black market in foreign currency. Nonetheless, some countries are highly successful at
using this method due to government monopolies over all money conversion. This was
the method employed by the Chinese government to maintain a currency peg or tightly
banded float against the US dollar. Throughout the 1990s, China was highly successful at
maintaining a currency peg using a government monopoly over all currency conversion
between the yuan and other currencies.[3][4]
Criticisms
The main criticism of a fixed exchange rate is that flexible exchange rates serve to
automatically adjust the balance of trade.[5] When a trade deficit occurs, there will be
increased demand for the foreign (rather than domestic) currency which will push up the
price of the foreign currency in terms of the domestic currency. That in turn makes the
price of foreign goods less attractive to the domestic market and thus pushes down the
trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur.
Government also has to invest many resources in getting the foreign reserves to pile up in
order to defend the pegged exchange rate. Moreover a government, when having a fixed
rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free
hand. For instance, by using reflationary tools to set the economy rolling (by decreasing
taxes and injecting more money in the market), the government risks running into a trade
deficit. This might occur as the purchasing power of a common household increases
along with inflation, thus making imports relatively cheaper.
Additionally, the stubbornness of a government in defending a fixed exchange rate when
in a trade deficit will force it to use deflationary measures (increased taxation and
reduced availability of money) which can lead to unemployment. Finally, other countries
with a fixed exchange rate can also retaliate in response to a certain country using the
currency of theirs in defending their exchange rate.
Fixed exchange rate regime versus capital control
The belief that the fixed exchange rate regime brings with it stability is only partly true,
since speculative attacks tend to target currencies with fixed exchange rate regimes, and

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