Fixed Versus Floating Exchange Rate System - Report Example

Fixed Versus Floating Exchange Rate System Exchange rate is the price of one nation’s currency expressed in terms of another nation’s currency. Governments determine the exchange rate system they apply according to many economic and political factors. In early history, all trade was barter exchange whereby goods were traded for other goods. Later, precious metals like gold and silver were used as the medium of exchange. From the late 1800s to the early 1900s, most of the major trading nations had their own fixed exchange rates under a system called the international gold standard, whereby the governments of countries guaranteed to redeem their currency for a specified amount of gold. The gold standard fixed a currency to something which was presumed to be more steady in value over time; however, due to other problems associated with a return to gold as the monetary support, a return to this type of system was ruled out. Most countries abandoned the gold standard during the 1930s. Today there are basically two types of exchange rates: fixed and floating. A fixed exchange rate denotes a nominal exchange rate that is set firmly with respect to a foreign currency or a basket of foreign currencies. Fixed exchange rates do not change, but remain fixed for ideally a permanent period of time. The government or its central bank acting on its behalf, is committed to a single fixed exchange rate. The government or central bank intervenes in the currency market constantly to ensure that the exchange rate stays as close to the desired target range as possible. This is usually done in two ways: raising or lowering interest rates, or, buying and selling its fixed interest rate securities. A floating exchange rate is determined in foreign markets depending on demand and supply, and it generally fluctuates constantly. Since the early 1970s, the major trading nations have had floating exchange rates where the price of a nation’s currency rises and falls in relation to world demand for that currency. Floating exchange rates change; they fluctuate year to year, month to month, week to week and even minute by minute. It is impossible to predict what a floating exchange rate will be at any foreseeable point in future. The factors which cause change in the market value of the exchange rate are changes in market demand and supply of the currency, changes in currency supply, changes in the currencies against which its rate is measured, changes in interest rates in different countries, and speculation with currencies. There are two types of floating exchange rate systems. The first type is called Free Floating Exchange Rate where no pre-determined target for the exchange rate is set by the government or central bank, and the exchange rate is affected by trade and capital flows; it is only market demand for and supply of the currency in the foreign exchange market that determines it value. The second type is called Managed Floating Exchange Rate where there is no pre-determined target for the exchange rate and the rate is decided through the forces of demand and supply; the exchange rate is floating, but the government or central bank may turn to interventions should there be any extreme fluctuations, and take steps to prevent an excessive change. This is a commonly used exchange rate system. For example, in the Czech Republic, the exchange rate was pegged to a basket of currencies until 1996 after which its economy began operating in the managed floating exchange rate regime. Apart from these two basic exchange rate regimes, a few countries have adopted a semi-fixed or semi-floating exchange rate system. Here, the exchange rate target limits are either specifically defined and the currency is permitted to move between those targeted limits, or, a crawling peg (in which exchange rates are adjusted on a regular basis) is fixed. Arguments for and against fixed and floating exchange rates These arguments can be viewed against the following three factors: Factor 1: Volatility and Risk Exchange rates that tend to suddenly fluctuate have a pronounced effect on traders and investors, making international trade and investment decisions more difficult due to the high potential of losing money because of a change in the exchange rate, increasing the risk of losses relative to plans, or increasing the costs to protect against those risks. From this perspective, the floating exchange rate system’s volatility is a natural day-to-day occurrence. Floating rates can be very volatile because they are driven chiefly by volatile capital inflows and do not necessarily move in line with purchasing power parity. However, a floating exchange rate’s actual changes over time – or in other words – its degree of volatility, may not be high: if its magnitude of change is less, and if it does not change quickly over time, then it will be deemed as being less volatile. Even in case of the fixed exchange rate regime, which by definition should not change and hence not be volatile at all, there is volatility in the form of frequent currency devaluation or revaluation. Therefore, even if in theory it seems that due to the perceived riskier floating exchange rate system countries should choose the fixed exchange rate regime, in practice it has not worked out as such. An IMF study (Exchange Rate Volatility and Trade Flows – Some New Evidence, by Peter Clark, Natalia Tamirisa and Shang-Jin Wei, May 2004) found that during the 1970s, 80s and 90s, the volatility of fixed exchange rates was approximately the same as that of floating rates, the effects of such volatility being concentrated in a very short time frame while having much larger economic impact. Two reasons were cited for this: one, a currency fixed to another reserve currency will continue to float against other currencies, and two, it is common for fixed currencies to be devalued or revalued periodically, and sometimes dramatically.1 Factor 2: Inflation Inflation is defined as a continual increase in prices throughout a nation’s economy resulting in a reduction in the purchasing power of money. Hyperinflation, which is rapid, uncontrolled inflation, can and has in the past destroyed the economies of nations. Two examples are Argentina which suffered hyperinflation during the 1970s and 1980s, and the German economy which collapsed after World War I ended in 1918. One effective way to reduce or eliminate inflationary tendency is to fix one’s currency exchange rate as this prevents the domestic money supply from rising too rapidly. For this measure to be effective over a long period of time, it is imperative that the country avoids devaluations because frequent devaluations will make the system similar to the floating exchange rate system where there is no effective control on the money supply and inflation can get out of control again. However, the fixed exchange rate system can also result in more, rather than less, inflation. This happened in the late 1-http://www.internationalecon.com/v1.0/Finance/ch110/F110-0.html 1960s and early 1970s when most of the developing countries were under the Bretton- Woods system of fixed exchange rates having the U.S Dollar as its reserve currency. Rapid increase in U.S money supply caused inflation in the U.S, and this inflation was exported to the other countries under the Bretton-Woods system. Inflation is cited as the major potential problem of countries with floating currency exchange rates. It is however argued that since the central bank controls the money supply, it can lower the money supply to raise interest rates and choke off rising inflation. This can be done by raising its reserve requirement or by selling government bonds. Factor 3: Monetary Autonomy Monetary Autonomy refers to the independence of a country’s central bank to affect its own money supply and then, through that, condition in its domestic economy. A country having the fixed exchange rate system loses the ability to control its economy because monetary policy (the program a nation follows to regulate its money supply) becomes ineffective as the rigidity of the fixed exchange rate system acts as a constraint. Since it is unable to use monetary policy to control the economy, the central bank loses it autonomy or independence. One of the key advantages of the floating exchange rate regime is the autonomy over monetary policy that it affords the country’s central bank. The central bank is free to control the money supply which in turn allows it flexibility in determining domestic interest rates, allows it to reduce unemployment and spur investment and domestic growth. If the domestic economy slips into recession, it is autonomous monetary policy that enables the central bank to boost demand, thus reducing the impact of economic shocks (such as sudden shifts in commodity prices) on domestic output and employment. National economies are vulnerable to asymmetric shocks, and many cannot cope with them without changing their exchange rates. With such monetary autonomy, monetary policy becomes a lever it can use to control the performance of the nation’s economy. Since monetary policy acts much more rapidly than fiscal policy, it is a much quicker policy lever to use to help control the economy. One of the reasons Britain decided not to join the Euro zone (as of 2005) is because it wants to maintain its monetary autonomy. It is important however for the central bank to maintain a prudent monetary policy whereby it is independent of the national government which makes government spending decisions, and whereby it has a clear guideline for its objective to satisfy the demands of a growing economy while maintaining sufficiently low inflation. Conclusion In the world of today where capital has become increasingly mobile, the exchange rate is one of the key international aggregate variables. Since the collapse of the Bretton-Woods fixed exchange rate system in 1973 after lasting almost 30 years, it has been difficult to maintain a credible fixed exchange system for a long period of time. The major developing nations intended to set up a new improved system of fixed exchange rates but this never materialized. Instead, countries embarked on a series of experiments with different types of fixed and floating exchange rate systems. For example in 2000, the EU countries created a single currency, the Euro, which replaced the members’ national currencies, thus effectively fixing the currencies to each other firmly. Some countries have fixed their currencies to a major trading partner; some others have fixed their currencies to a basket of currencies comprising several major trading partners; a few other nations have implemented a crawling peg where exchange rates are adjusted on regular basis; while other countries like the U.S have allowed an almost pure float with central bank intervention only on rare occasions. The results of all these experiments have been mixed. Sometimes floating exchange rate systems have worked excellently, yet in some cases they tended to overshoot and became extremely unstable. Similarly fixed exchange rate regimes have at times appeared to be a boon especially in reducing inflationary pressures for at least a period of time, but at other times it caused the import of excessive inflation from the reserve country. The constraints imposed by rigidly fixed rates may be extremely expensive and they impose very tight constraints on monetary policy. In conclusion it can be said that no one system has operated flawlessly in all circumstances. Both types of exchange rate regimes have their pros and cons. It is recommended that countries adopt that system which best suits its particular conditions. References: Fixed vs Floating Exchange Rates: Overview http://www.internationalecon.com/v1.0/Finance/ch110/F110-0.html Fixed vs Floating Exchange Rates http://www.arabia.msn.com/Money/Education/ Fixed vs Floating Exchange Rates: Czech National Bank http://www.cnb.cz/www.cnb.cz/en/monetary_policy/basic_terms/ fix_float_exchange_rate.html Read More