Exchange Rate Regimes - Term Paper Example

Table of Contents Page Introduction......................................................................................................... 2 2. Literature Review............................................................................................... 3 3. Exchange Rate Regimes and practical experience in UK............................... 7 4. Exchange rate Regimes and Financial crisis.................................................... 9 5. Financial markets and Institutions................................................................... 11 6. Conclusion........................................................................................................ 12 7. References........................................................................................................ 14 8. Appendices....................................................................................................... 16 International Financial Management 1. Introduction The exchange rate can be defined as the rate at which the national currency exchanges in terms of a foreign currency. Thus the exchange rate of a country is expressed in the form of a ratio or a multiplier depending on the central bank’s policy of the particular country. The exchange rate regime is the way that a particular country manages its local currency in respect with foreign currencies in the foreign exchange market. The exchange rate regime basically depends on the fiscal/monetary policy mix of a particular country and the exchange rate is determined by the central bank of the country. The basic types of exchange rate regimes are the fixed exchange rate and the floating exchange rate. In the latter case the market decides the movements of the exchange rate. Exchange rate volatility is a common denominator of a country’s exposure to international risk through foreign transactions, whether international trade or investment (Madura, 2009). The higher the degree of exposure the higher the degree of risk associated with such exposure. Thus the exchange rate can be considered as an important indicator in monetary policy and it mainly depends on the monetary policy framework of a particular country. Exchange rate can be identified as a target for particular government’s policy and that it can actively manage with the other components of a monetary policy such as inflation, balance of payments and so on. For instance the changes in exchange rate in a short term can impact on the real economy and the balance of payments and in the long term those effects can be adjusted with the exchange rate movements. Therefore developing countries that depend on commodity exports to a greater extent are more likely to face a greater degree of risk due to the fact that commodity prices in international markets are subject to huge fluctuations. As a result their currencies against those of advanced industrialized economies are weaker. Even the well developed countries especially UK has been faced with this reality but their ability to manipulate exchange rates in international markets is considerably higher when compared to those developing countries (Wheele, 1995). 2. Literature Review Currently available literature on the subject of exchange rate regime and related price stabilization policy in a modern economy has both a theoretical approach and a broader empirical approach. Price stabilization policy refers to a government macroeconomic strategy designed and executed by the central bank to ensure stable economic growth based primarily on stable prices and lower unemployment levels. This is a contingency macroeconomic model that presupposes a smoothing out effect on erratic fluctuations in aggregate supply. Alogoskoufis (1992) shows that the broader policy level approach includes monitoring and adjusting cyclical growth process and interest rates so that aggregate demand can be managed to achieve broader macroeconomic policy goals. This paper emphasizes on different types of exchange rate regimes, advantages and disadvantages of possible regimes, collapse of exchange rate regimes after the crisis and to see which of these exchange rate regime is favored by the UK and for what reasons. Thus there can be identified mainly three exchange rates – nominal; real; and multilateral. Nominal exchange rate is determined by the currency financial markets known as foreign exchange market which functions similar to the stock exchange market. Particular countries’ central banks are also participating to the process of determining the nominal exchange rate. Hasan, & Wallace (1996) pointed that at the time of inflation real exchange rate would be utilized by the countries in order to determine the actual trade value between two countries. Real exchange rate is determined by the country’s inflation rate. At the time of inflation the nominal rate would be replaced by the real exchange rate and central bank and the inflation rate would be determined the real exchange rate. Some countries would prefer to use two or more number of currencies for the trade purposes. It is determined by the demand and supply of the economy and financial market with relating to banking transactions. Thus adaptation of multilateral exchange rate is regarding as a pool of different foreign currencies and the process required some degree of capital controls. The purpose of adopting this rate is centralized the commercial and public transactions and control the imports and consumptions in the country. There are different regimes available to determine the price of a currency. Dubas (2009) identified that fixed exchange rate regime and floating or flexible regime are the frequently adopted regimes by various governments. When the exchange rate can move freely, and allow demand and supply to determine the conversion rate, it is called the floating exchange rate. Thus it is called flexible exchange rate as well. In a floating exchange rate regime if and when the currency value decreases it is called depreciation and an increase is called appreciation of currency. The floating rate is determined by market demand for and supply of the currency. Therefore it is a more competitive and successful method to adopt than the fixed rate, because the market’s invisible hand will control the flow of the currency and exchange rate. Thus there is a less opportunity for investors to indulge in speculation and hedging activities and to earn profit at the expenses of the central bank. Therefore the adoption of floating rate regimes makes black market activities less possible. Another advantage of the floating rate is that it balances the demand and supply for currencies. So this will enable the government to maintain current account transactions at a healthier pace. Despite the above advantages some disadvantages too can be identified. The floating rate carries a risk of inflation in the economy and there is an uncertainty in the economy due to the regime. So long term economic planning and adoption of certain pricing methods would be difficult. The floating rate always conflicts with the country’s monitory policy so it is difficult to stabilize the exchange rate and economic variables. Kanas, (2005) showed that importers may often find difficulties in financing for their imports where as fixed rate would be certain and in those condition it is easy to plan and carry the economic transactions. Fixed exchange rate is set by the central bank of the particular country. In United Kingdom bank of England decides the fixed exchange rate for the commercial and public transactions. In fixed exchange rate system loss in the local currency’s international value is called devaluation and thus increase is called revaluation. Fixed exchange rate regime is reducing the uncertainties of the all economic activities in the country. It is durable and facilitates the business environment with assurance to plan the process for a long time and fixed pricing of exports and imports will boost the international trade and the economic development of the country. Fixed rate regime ensures the financial discipline on the economy of the country because it does not change frequently. Therefore economic planning will be easy thus attracts long term foreign direct investments to the country. This regime is not certain because the central bank of the country can any time abandon this regime depending on the economic circumstances. Government or central bank can change the monitory policies. So in keeping with those policies, the exchange rate regime will be changed. Bradley & Moles (2002) argued that when the central bank adopts fixed exchange rate regime for their currency it always required to maintain an adequate quantity of foreign exchange reserves in order to balance the external current account transactions. The fixed rate regime does not determine and represent the real exchange rate. When the central bank determines the rate it does not consider the price level changes (inflation) of the economy. The fixed rate lacks the complete credibility and thus damages the monitory stability and foreign exchange reserves of the country. Due to this reason hedging and speculation activities will be initiated by the rational investors. So these factors are likely to force the central bank to abandon the fixed rate regime. Fixed rate regime requires regular concurrence with the domestic fiscal policies to be more beneficial to the economy, because the government adopts this exchange rate, by manipulating the interest rates. Due to this reason countries demand for the currency can be increased and unfit trade practices of the economy can be increased due to increase in demand for the currencies. So this condition is not always beneficial to the economy and long term economic planning of the country. Many governments adopt floating exchange rate to a certain extent for the benefit their economic activities. Thus it is governed by the country’s monitory policies. But if the exchange rate depreciates continuously it may badly affect the economic activities in the country such as increasing the cost of imports, reducing investments and so on. Thus this situation can lead to inflation in the country if the central bank does not get involved and control the situation. So it is the responsibility of the central bank of a country to maintain the stability of the exchange rate. Therefore central bank will interfere in the determination of the exchange rate of a country. In reality no currency would be determined by fixed or floating rates but the market conditions such as inflation and the degree of the control of central bank . According to Kara, & Nelson (2003) an effective exchange rate regime should ensure a balance in the external current account and equilibrium in the capital account. Thus it should be capable of managing the overall domestic and international price levels in respect of balancing export prices with those of competitor countries’ by reducing domestic and international unit cost. 3. Exchange Rate Regimes and practical experience in the UK The United Kingdom is located in northwestern coast of Europe Continent which consists of the islands of Great Britain, North Ireland and small islands. The UK is known as a developed country and it accounted as 6th largest economy according to its exchange rate, Gross Domestic Product (GDP) and Purchasing Power Parity (PPP) and 3rd largest in Europe. Thus the UK is remaining as a major powerful country especially with its strong economic and political influences. It is governing by a parliamentary system and it legislating the foreign affairs and defense behalf of the UK government. The Bank of England, the central bank of the UK which is responsible in issuing its currency of sterling pound (£) and it is considered as a world third largest currency reserve by the UK governments and financial institutions. However due to the global economic and stock market crisis it weaken the value of the sterling in the global market. Each country needs to identify the most suitable exchange rate regime for the successful managment of the economy. For instance the UK operated a managed floating rate from 1973 to 1990 period. However there have been some intervened by the central bank to control the exchange rate and also government controlled its interest rates fluctuations. In the period of October 1990 to September 1992 UK operated a semi-fixed exchange rate system and also the country became the member of the European exchange rate mechanism (ERM). During that period Sterling Pound was allowed to vary between 6% either side and at that time the exchange rate was a specific target of the UK economic policy. Thus the interest rate also had to be set at a consistent level within the allowed ERM limits (Ashton, & Hudson, 2008). However from September 1992 to 1997 UK has operated a free-floating exchange rate which is purely determined by the market demand and supply and also without any intervention by the Bank of England. Figure 1: A Floating Exchange Rate System Pesos per dollar Supply of dollars S Demand of dollars Q Quantity of dollars per day However by using literature collected from the library and internet sources it has been determined that the UK primarily uses the most common and accepted exchange rate regime of managed floating as adopted by most of the developing and developed countries in the world. for example currencies of dollar, euro, yen and British pound can be regarded as the floating currencies (Edwards, 2002). However the central banks of these countries consistently intervene and influence to the exchange rates by currency buying and selling in order to avoid the excessive currency depreciation and appreciation. This exchange rate regime is known as the managed float or else dirty float regime. Managed floating exchange rate is basically determined by the market demand and supply of the particular currency and central banks would intervene regularly to manage the discrepancies of the exchange rates. Thus there can be identified main arguments of adopting floating exchange rates in the UK context. In the first instance there is less need in large scale of gold and foreign currency reserves for the central bank of England. Also it can be regarded as a useful regime to the country in order to do some adjustments to the economy when it is required. For instance by depreciating the currency it can boost the export and ultimately the economic growth of the country. Floating exchange rate facilitates the country to adjust the disequilibrium in the balance of payments, because large discrepancy of the trade deficits will puts downward pressure on the exchange rate and it would positively impact to the export sector in the UK due to the fact that relatively expensive of the product will discourage the demand for imports (Aggarwal, & Goodell, 2009). Thus the floating exchange rate and freedom of the domestic monetary policy has been allowed Bank of England since 1997 to meet macroeconomic objectives of the domestic economy such as controlling inflation and stabilizing the economy. However the combination of fiscal and monetary policy in the UK may achieve macro-economic balance but it might cause a decline in manufactured goods. Even though the subject of currency management is a broad one its applications are limited as only a few concepts and strategies are actually used in real world situations. 4. Exchange rate Regimes and currency-stock market crisis Exchange rate regimes and investment analysis for making effective economic strategies have been the preoccupation of many governments with a variety of change in monitory and fiscal policies in recent past. However the focus on the strategic importance of exchange rate regime adopted in the UK has to be examined against the backdrop of a rapidly evolving financial and economic landscape that essentially characterizes the basis on which such exchange rate regimes operate and grow. In the UK money market, such expectations are based on the relative stability gains such as reduced market volatility and fluctuations in price differentials. In currency stock market crisis Depreciation of domestic currency against a foreign currency increases export velocity of the country, because exporters will earn more money out of their exports (Allen, 2009). So currency crisis can be beneficial to the exporters and thus it balances the country’s current account transactions. Thus the depreciation of local currency is favorable to a country because it discourages the imports. The prices of the imported goods will rise shapely in this situation so Instead of foreign products local customers will prefer to buy domestic products and many import substitutions will be introduced to the economy. The bank of England adopting different strategies and frame works through their monitory policy to stabilized interest rate, exchange rate and the other variables. Thus the floating exchange rate regime is a practice that has adapted by central bank in the UK in order to reduce exposure to unwanted risk and minimize price fluctuations associated with such developments like inflation, changes in interest rates and exchange rate volatility. The stock market crash can be identified as a situation in which a stock market experiences a sudden and major decline in value of its underlying stocks. A global financial crisis almost making simultaneous decline in both exchange rate and stock market figures. Increase in currency and stock market crisis affect more on the macroeconomic determinants of stock market and currency crisis in emerging economies. Rational investors can predict the stock market crisis by using the information from market behavior and global economic circumstances but many empirical studies proven and argued that exchange rates would affect stock market returns. Thus the stock market crisis in 2008-2009 caused to close some of the financial markets and institutions in the UK (Krugman, 2008). Stock market crisis can directly impact on currency market values, capital flows and financial stability of the country. Also most of developed countries such as UK has affected negatively in the growth performance due to the number of reasons such as rising fiscal surpluses, decreases the exports, increasing unemployment, falling consumer demand and stagnant investment. Reserve currency is surplus of foreign currencies which the government has held in quantities in order to maintain a balance and utilize them in a currency crisis. These securities will enable the government to buy the imports at relatively lower price than the competing countries. United Kingdom’s currency was the only currency recognized by world economy as a reserve currency in past century. But due to the dominance of United States economy resulted in sterling decrease its value as the world’s most reserve currency. The reserve currency is basically determined by the central bank of the country and in UK bank of England selects the top reserve currency. The dominant of the local currency of a country in the world will take relatively a long time. Recognition and the stability of the currency is needed in order to achieve this goal. 5. Financial markets and Institutions Financial markets and institutions can be regarded as a mechanism which would allow investors to trade financial securities, thus it is an institution or intermediaries that provides financial services. These institutions are mostly governed and regulated by the government. The financial markets consists of different types of markets - capital markets, e.g. stock markets and bond markets; commodity markets; money markets; derivate markets; insurance markets; and also foreign exchange rate markets. Financial markets and institutions operate on the principle of demand and supply, and therefore interest rates and rates of other financial instruments such as government securities have a substantial impact on the related outcomes. However it’s the fast changing institutional environment – banks, Financial Service Authority, financial institutions, portfolio management and investment funds, mutual funds and even the pension funds – that requires a greater degree of attention here (Simon, 1992). Above all their legal paradigms have been evolving in a manner that requires greater analysis. London Stock exchange can be identified as one of the largest stock exchange in the world and it has four major areas such as equity markets, trading services, information services and derivatives. Bonds have an assured constant return over its life time till the time of maturity. In the first instance commercial banks in the UK have been regarded as the main players in money markets though their operations are basically characterized by the scope and freedom available to carry out hedging operations. They are by both the fund users and suppliers. It is a significant part of the money supply and it facilitates to redistribute the net excesses and shortages of the money market. Thus mutual funds accept deposits from potential investors and reinvest money in a combination of unit trusts or/and other investment vehicles such as stocks bonds and government securities. These financial institutions and services have a considerable bearing on the determination of exchange rate and control the currency crisis. Effective financial system of the country can stabilized the exchange rate to balance their current account transactions to avoid negative effects on balance of payments. 6. Conclusion Finally it must be noted that effective exchange rate regimes have facilitated a more transparent marketplace for the country where individuals and firms will have to face significant changes and uncertainty in the financial markets. In fact this uncertainty leads to volatility in the market and arise a need for an efficient exchange rate regime to ensure the stability of the future financial status and the macro-economic policy related benefits to the country. Therefore UK needs to survive against the currency risk with trying to minimize their involvement with volatile currencies such as Japanese Yen. On the other hand financial markets and institutions are exposed to risks associated with changes in exchange rates in two ways, i.e. they are influenced by interest rates and cash flow at the same time. Thus this paper has adequately accounted for the aftermath of outcomes related to changes in real exchange rates with special focus on the long term and short term analyses separately. It has conclusively proved that exchange rate exposures have a degree of strategic solution through the inherent dynamics of interest rate and cash flow changes across a broader time period. However there is no universal exchange rate practice in the world and the selection of a particular regime is basically depends on the particular circumstances of the country. Federal authorities such as the Financial Service Authority in the UK and state regulators and legislatures have been hard-pressed to come up with logical and alternate laws to cope with the particular exchange rate regime. Therefore authorities have to act much faster with ruthless efficiency to tackle the problem and above all they have to identify the structural bottlenecks of the existing exchange rate regime system in order to overcome the hitherto insurmountable problems. 6. References 1. Aggarwal, R & Goodell, GW 2009, ‘Markets and institutions in financial intermediation: National characteristics as determinants’, Journal of Banking & Finance, vol. 33, no. 10, pp.1770-1780. 2. Allen, F 2009, Understanding Financial Crises (Clarendon Lectures in Finance), Oxford University Press, New York. 3. Alogoskoufis, GS 1992, ‘Monetary accommodation, exchange rate regimes and inflation persistence’, Economic Journal vol. 102, pp. 461-80. 4. Ashton, JK & Hudson, RS 2008, ‘Interest rate clustering in UK financial services markets’, Journal of Banking & Finance, vol. 32, no. 7, pp. 1393-1403. 5. Bradley, K, Moles, P 2002, ‘Managing strategic exchange rate exposures: evidence from UK firms’, Managerial Finance, vol. 28, pp.28-42. 6. Craine, R 2002, ‘Exchange rate regime credibility, the agency cost of capital and devaluation’, Journal of Economic Dynamics and Control, vol. 26, no. 9-10, pp. 1431-1456. 7. Dubas, JM 2009, ‘The Importance of the Exchange Rate Regime in Limiting Misalignment’, World Development, vol. 37, no. 10, pp.1612-1622. 8. Edwards, S 2002, Exchange Rate Regimes, Capital Flows, and Crisis Prevention, in Economic and Financial Crises in Emerging Market Economies, University of Chicago Press, Chicago. 9. Hasan, S & Wallace, M 1996, ‘Real exchange rate volatility and exchange rate regimes: Evidence from long-term data’, Economics Letters, vol. 52, no. 1, pp. 67-73. 10. Kanas, A 2005, ‘Regime linkages in the US/UK real exchange rate–real interest differential relation’, Journal of International Money and Finance, vol. 24, no. 2, pp. 257-274. 11. Kara, A & Nelson, E 2003. ‘The Exchange Rate and Inflation in the UK’, Scottish Journal of Political Economy, vol. 50, no. 5, pp. 585-608. 12. Krugman, P 2008, The Return of Depression Economics and the Crisis of 2008, W. W. Norton, New York. 13. Madura, J 2009, International Financial Management, South-Western College Pub, New York. 14. Simon, DS 1992, ‘UK Financial Institutions and Markets’, The British Accounting Review, vol. 24, no. 3, pp. 303-304. 15. Wheele, M 1995, ‘Money, income, and exchange rate regimes: Evidence from the UK’, Atlantic Economic Journal, vol. 23, no. 2, pp. 85-96. 7. Appendices Figure 1: Determination of the rate of exchange 2.20 S by UK 2.00 b a 1.80 $ Price of £ 1.60 1.40 1.20 D By USA 1.00 0 QD QS Q of £ Source: http://www.bized.co.uk/educators/he/pearson/models/bop.ppt Figure 2: Determination of the rate of exchange 2.20 S by UK 2.00 1.80 $ Price of £ 1.60 d c 1.40 1.20 D By USA 1.00 0 QS QD Q of £ Source: http://www.bized.co.uk/educators/he/pearson/models/bop.ppt Read More