You are on page 1of 37

Lecture

7_8

Flexible and Fixed


Exchange Rate System
By Preeti Singh

FIXED AND FLEXIBLE EXCHANGE


RATES

Flexible Exchange Rates


Semi Fixed Rate System
Flexible Exchange Rates
Liberalized Exchange Rate
Management System (LERMS)
1992
Unified Exchange Rate 1993
Current Account Convertibility
Capital Account Convertibility

Fixed Exchange Rates


Gold standard
Bretton Woods
Pegged rate
Currency board

Semi Fixed Rate


System
Bands
Target zones
Pegs and Baskets
Crawling peg
Floating rate
system

Floating Rate System


It is a market determined rate of
interest.
RBI has made the value of the rupee
within a band and according to the
basket of currencies mechanism.
It uses the American dollar as the
intervening currency.

Flexible Exchange Rates

Flexible exchange rates are


determined by the free play of
demand and supply of foreign
exchange.
The flexible exchange rates are
known as fluctuating or floating
exchange rates.
The exchange rate is also

Nominal, Real and Effective


Exchange Rates
The nominal, real and effective
rates are depicted of domestic
currency as per unit of foreign
currency to make an analysis of
the effects and changes in the
foreign exchange rate.
Nominal exchange rate
Real Exchange rate
Effective exchange rate

Nominal exchange rate

The nominal exchange rate


is the prevailing exchange
rate at the time when it is
being analyzed.
It is the price of one
currency
in
terms
of
another.

Real Exchange rate


The real exchange rate measures
the purchasing power of a currency.

It can be calculated by adjusting


the nominal rate of exchange for
relative
prices
between
the
countries that are being analyzed.

Effective
Effective Exchange
Exchange Rate
Rate
The effective exchange rate
measures whether the price of a
currency
is
appreciating
or
depreciating
against
the
weighted basket of currencies
with whom the country desires
to trade.
The real effective rate changes
without any change in exchange

Flexible and Fixed Exchange


Rate System
Floating Exchange Rate
Since 1973, most industrial countries and many
development countries allowed their currency
to float with government intervention in the
foreign exchange market.
Crawling Peg
Crawling peg is also called sliding and gliding
parity.
It is a cross between a fixed rate and fully
flexible system.
They are semi fixed system but not floating
system.

Crawling peg were developed to adjust the


rate slowly by small amounts at any point of
time on a continuous basis to correct over
valuation and under valuation.
The small adjustment between 0.5% per
month or 6% for the whole year was
designed to discourage speculation by
setting an upper limit that speculators could
gain from devaluation in one year.
The disadvantage of this system is that it
requires countries to have ample reserves
for process of adjustments.
Minor adjustment may not correct currencies
over valuation and under valuation.

Wide Band

Objective of wide band is to compensate


for the rigidity of the fixed rate systems.
They are similar and yet different to
adjustable peg system.
Wide band allows currency value to
fluctuate 5% on each side of the par.
This
system
uses
more
flexible
movement to warn speculators for more
adverse consequences when prediction
of direction of exchange rate proves to
be wrong.

Type of Wide Band


A group of European Nations used a
particular form of wide band.
Exchange rate gyrations since the abolition
of fixed rate was a special problem for
European countries because of their
dependence on trade within the block.
Snake was created for less formal of stable
but floating rates among their currencies.
Goal was exchange rate stability, unity &
cooperation.

West
Germany,
Benelux
and
Scandinavian countries in April 1972
entered into European Joint Float
Agreement called the snake.
The snake is a system of stable but
floating rates.
It is a currency band that links these
countries currencies and their values
fixed against one another in narrow
band of 2.25% above and below the
par value.
The 4.5% limit for joint twists of the

The snake had too many problems so


it could not achieve its goal.
It was unable to protect the member
currencies from the dollar slump in the
1970s.
Currencies were forced out of the
snake
by
divergent
economic
conditions in the member countries
recurring
market
pressures
and
member
countries
pursuit
of
independence objectives.
Based on their economic policies

In the wide band scheme, a country with more


inflationary policies will find the prices of the
international goods going up requiring a
depreciation program to correct the countrys
balance of payments in order to slow growth
and curve inflation while eventually risking
recession.
The countries exchange rate would then sink
towards the floor under its par value.
One fixed limit is reached after hitting either
floor or ceiling the country goes back to the
rigid fixed rate again.
If wide band is desirable because of increase in
flexibility, a country may be better of with no
limit for movement at all.

Flexible Floating System


In August 15, 1971 US suspended convertibility
of dollar into gold and other reserve assets and
floated the dollar to change in the parity and
review of IMF.
The Smithsonian Agreement brought about
revaluation of many currencies and devaluation
of US $ by 10.35%.
In February 1973, second devaluation of 10%
was brought about by US.
Foreign exchange markets closed down in
Europe and Japan for 2 weeks.
When markets reopened, all major currencies
were allowed to float.

Dollar sank for 7 weeks due to balance of


payment deficit.
Watergate scam brought about inflation in
US and tightening of money abroad.
With dollar free to float speculator pressures
showed a fall in the exchange value of the
dollar without closing in the market.
The devaluation helped the US to improve
its trade performance.
In October 1978, US $ crisis happened as
there was panic selling of the dollar and
stock markets fell.

Flexible System
In a flexible system, market is based on
demand and supply to determined
currency values.
A surplus in the country results in
appreciation of the currency.
It also creates higher prices increase in
reserves and opportunity costs.
Too much reserve reduces investment
opportunities.
A country deficit will lower its currencys
value, make it easier to export.

FLOAT
In
the
absence
of
government
intervention, float is set to be clean.
Float is dirty when central bank
intervention influences exchange rates.
A country with inflation must reduce
public spending and money supply to
cool the economy.
Government intervention is to gain trade
advantage.
Too
much
competitive
devaluation
creates filthy float

Evaluation of Floating
Rates

Fixed rate and floating rate system have


different characteristics.
The systems cannot have same goals of
certainty, stability and inflation control.
Fixed rate plan are rigid but experts
preferring rigidity state that it brings
economic efficiency, public confidence and
inflation control.
Experience shows that fixed rates do not
work for a long time but from 1792 to
1971, fixed rates continued.

For fixed rates to work the gold price


must be fixed to control inflation
which is impossible.
Fixed rates also bring about massive
capital flows in a crisis and closing of
financing markets.

Types of Currency
System
Floating currencies are said to encourage
inflation in fact it makes it more apparent.
More Flexible Exchange Rate Systems : Japan
and US are in this arrangement and allow it to
float in relation to each other.
Government intervention has an impact on
currency value on the short run.
Managed Floating Exchange System have no
official bands on currencies.
Government intervenes to get its objective done. It
allows government to implement their policy
within a relative flexible exchange rate system
and to coordinate policies with other government.

Pegged Exchange Rate: In pegged


exchange rates are fixed in relation to
other currencies such as US dollar,
Euro and Currency Basket with SDR or
reserves by IMF.
The disadvantage of a central bank to
fight the market maintain the system if
inflation rate in two countries is the
same.
Limited Flexible Exchange Rate
System: These are two types (a) Golf
Countries and (b) European Exchange
Rate Mechanism.

This system combines fixed pegged


period and floating rate more flexible
system.
In 1999, ECU was renamed Euro and
currencies in the ERM were pegged
to the central rate.
ERM moved from limited flexibility to
the pegged portion expect Denmark
all other countries chose to peg their
currencies to the Euro.

Fixed Versus Floating Exchange


Rates
Volatility in foreign exchange rates
represents a cost of doing business
internationally
and
imposes
considerable risk on investments
overseas
Historically governments tried to
avoid this cost by fixing exchange
rates at some predetermined level

Fixed Versus Floating Exchange


Rates
Fixed exchange rate system
This was the system maintained globally
from 1944 until the early 1970s.
It came under the supervision of the
International Monetary Fund (IMF)
After the collapse of the fixed exchange
rate system, it was resurrected with a
more limited scope in 1979 for the major
European countries

Fixed Versus Floating Exchange


Rates

Fixed exchange rate system


The most recent example of a fixed
exchange rate is the introduction of the
Euro as the common currency of the 12
members of the European Monetary
Union
This new monetary union sets the
exchange rate between the Euro and the
member countries national currencies
at a fixed rate
Individual
member
countries
are
expected
to
maintain
domestic

How Fixed Rates Are Supposed


to Work
The correction process under a floating
exchange rate system
Country runs a balance-of-payments deficit
Supply of its currency offered on world
financial markets exceeds the demand
The currency will be depreciated in value
relative to other markets
This adjustment brings the international
payments into equilibrium

Fixed Versus Floating Exchange


Rates
Example: British Pounds and US Dollar
How Fixed Rates Are Supposed to
Work
Under a fixed exchange rate system
fluctuations are prevented from occurring
through government intervention
Floating Rate System
The supply curve of British Pounds shifts to the
right because British tastes have shifted toward
increased purchases of American goods
This increased supply of pound would put
downward pressure on the value of the Pound
Under a floating rate system the new lower
equilibrium point would be reached where quantity
supplied of pounds equals the quantity demanded
of pounds

In (a), with floating rates, the pound depreciates; in (b),


with pegged rates, the British central bank prevents the
decline by buying up the excess supply of pounds.

Fixed Versus Floating Exchange


Rates
How Fixed Rates Are Supposed to Work
(Fixed Rate System)
Under this system, the British government would intervene
in the foreign exchange market and purchase the excess
pounds available at the predetermined fixed (pegged) rate
Britains international reserves are used to purchase the
excess pounds which prevents the exchange rate from
falling below the pegged rate
Traditionally these international reserves consist of gold,
U.S. dollars, other major currencies, and now the Euro

(a), with floating rates, the pound depreciates; in (b),


with pegged rates, the British central bank prevents the
decline by buying up the excess supply of pounds.

International Financial
Crises
Major problem with a fixed rate system is
that
it
contains
no
self-correcting
exchange rate mechanism to eliminate a
countrys persistent balance-of-payment
deficit
A continual balance-of-payment deficit
suggests domestic economic structural
problems relative to the rest of the world
Eventually the country will run out of
international reserves and be forced to
devalue which will eliminate the deficit

International Financial
Crises
The expectation of a devaluation will
cause
the
international
financial
community to take actions that will
increase the likelihood of the anticipated
devaluation
Individuals will sell the threatened currency in
the international market
This increases the supply of the currency which
increases the downward pressure on the value
This capital flight will further deplete the
countrys international reserve and speed up
the devaluation

International Financial
Crises
Currently industrialized countries practice
a managed float system
The exchange rate is permitted to vary within a
predetermined band
If foreign exchange markets attempt to push
the value of the currency outside the band
(both above or below), central bank will
intervene
However, if the central bank is intervening an
excessive amount, it is likely that country will
be forced to devalue or revalue its currency
to recognize structural changes in local
economy