Exchange Rate Regimes

What are fixed Exchange Rates?

- Officials commit to maintaining the exchange
rate at a specific level.
What are Floating Exchange Rates?
- No intervention from bankers or government
officials. The market determines the price of the
currency.
What is a clean float? A dirty one?
- With a dirty float the government doesnt peg the
currency, but tries from time to time to influence the
rate by buying or selling in the currency markets.

Exchange Rate Regimes

What is a clean float? A dirty one?
- With a dirty float the government doesnt peg
the currency, but tries from time to time to
influence the rate by buying or selling in the
currency markets.
Fixed Exchange Rates:
The government must buy the amount that will bring
the quantity demanded back to the original level

Fixed Exchange Rates

How can the government keep a currency at a
certain value if international commerce becomes
unwilling to pay that price?
It cant maintain the value for long. If the demand
for the currency falls, its price would fall as well.
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

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?
How does the government defend the fixed
value against any market pressures pushing
toward higher or lower exchange rate value?
In the past, all currencies were fixed to gold.
Today, a country can fix its value to another
countrys 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.
How can higher i rates keep the currency value up?
(Answer: Foreigners will purchase the nations currency,
bidding its value upward, to make short-term investments
in the country.)

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 countrys
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

3. The government can also make long-term adjustments of
its macroeconomic (monetary and/or fiscal policy).
Budget austerity (self-denial because of external
pressure) avoids inflation and takes downward pressure
off currency.
3. Why does inflation put downward pressure on a
countrys exchange rate?
Non-inflating countries are unwilling to pay more and
more to buy an inflating countrys 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
countrys 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.
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.)
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 dont 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.
5. The Mexican government soon runs out of reserves and
lets the peso price fall.
6. 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.
What is a pegged exchange rate?
The term pegged exchange rate refers to setting a targeted value
for a countrys foreign exchange, and it indicates the govt. has
some ability to move the peg.
Clean Float
Supply and Demand are solely private activities
Complete flexibility
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

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 countrys international position develops (e.g.,
demand for the currency is too weak to maintain the desired value).
A crawling peg can be changed often (monthly, say) according to a set
of indicators or the judgment of the countrys 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

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
macroeconomic
situation, a
country increases
its money supply
so that banks are
more willing to
lend.

The overall
payments balance
worsens.

Interest rate
drops

Real spending,
production, and
income rise, but
The price level
increases.

The Current account

balance worsens as
exports fall and imports
increase.

Monetary Policy with Floating Exchange Rates

Effects of Expanding the Money Supply
Capital flows out.
(In the short run)
With an
increase in the
money supply,
banks are
more willing
to lend.

Currency
depreciation and
automatic
adjustment begins!

Interest
rate
drops

Real spending,
production, and
income rise.

Current account
balance worsens.

The Price level

increases.
(Beyond the short run)

The
Current
account
balance
improves

Real
product
and
income
rise more

In Conclusion
Fixed exchange rates are government controlled.
Floating exchange rates are market driven.
Governments have always preferred the improved
business climate of fixed rates
They reduce the uncertainty of unstable currency
values (note the European Monetary Systems fixed
rates of the 1990s).
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.

Kenen on Fixed and Floating Rates

Times have changed since the early 1970s and Nixons destruction
of Bretton Woods. Markets have developed to hedge exchange risks
and we have become accustomed to the uncertainties associated
with them. Trade flourishes.
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 beggarthy-neighbor trade policies to cope with output-reducing shocks.
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

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.
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 macroeconomic policy decision a country makes.
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.
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.
Were 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.