982 Fixed Floating Exchange Rates

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Information about 982 Fixed Floating Exchange Rates

Published on April 9, 2008

Author: The_Rock

Source: authorstream.com

Fixed and Floating Exchange Rates:  Fixed and Floating Exchange Rates A2 Economics A2 Economics PowerPoint Briefings 2006 tutor2u™ Exchange Rate Systems:  Exchange Rate Systems Countries can choose their exchange rate system: (1) Free-floating exchange rate (2) Managed floating system (3) Semi-fixed exchange rate system (4) Fully-fixed exchange rate system (5) Monetary Union with other countries The Sterling Exchange Rate Index:  The Sterling Exchange Rate Index Floating Exchange Rates:  Floating Exchange Rates The value of the currency is determined purely by market demand and supply of the currency Both international trade flows and capital flows affect the exchange rate under a floating system No target for the exchange rate is set by the Government There is no need for official intervention in the currency market by the central bank Sterling has floated freely on the foreign exchange markets since the UK suspended membership of the ERM in September 1992 Managed Floating Exchange Rate:  Managed Floating Exchange Rate Currency is usually determined by market forces Some currency market intervention might be considered as part of demand management (e.g. a desire for a slightly lower currency to boost export demand or the desire for a stronger currency to control inflationary pressures) Interest rates may be changed to affect the market value of the currency No attempt is made to influence the long-term external value of the currency There are limits to the effectiveness of intervention in markets where the power of speculation can be fierce Semi-Fixed Exchange Rate:  Semi-Fixed Exchange Rate The exchange rate is given a specific target The currency can move between permitted bands of fluctuation on a day-to-day basis Exchange rate becomes an target of monetary policy-making (e.g. interest rates are set to meet the exchange rate target such as when the UK was in the ERM). The central bank must intervene to maintain the value of the currency within the set targets if it moves outside the agreed range Re-valuations of the currency are seen as a last resort or when intervention is proving ineffective Fully-fixed exchange rate:  Fully-fixed exchange rate The government makes a commitment to a fixed exchange rate The exchange rate is pegged There are no fluctuations from the agreed central rate Examples? This system achieves exchange rate stability but perhaps at the expense of domestic economic stability A country can automatically improve its competitiveness by reducing its costs below that of other countries – knowing that the exchange rate will remain stable China and the US dollar:  China and the US dollar China has been criticsed by those who say its fixed-rate monetary policy boosts exports by keeping the yuan currency at a low level. Currency Boards:  Currency Boards Currency board: a country commits, by law, to exchange domestic currency for a specified foreign currency at a fixed rate. Example: Argentina adopted currency board between 1991-2001 when one peso can be exchanged to one dollar. To maintain the currency board arrangement, the constitution of Argentina specifies that the amount of domestic money supply cannot exceed the country’s foreign reserves. Currency boards - Argentina:  Currency boards - Argentina UK Economic History:  UK Economic History 1973-1990: UK operated with a managed floating exchange rate. There was some intervention by the central bank to influence the exchange rate and government was in control of interest rates October 1990- September 1992: UK a member of the European exchange rate mechanism (ERM) – the exchange rate was a specific target of economic policy September 1992 – present day: the UK has operated with a free-floating exchange rate – no intervention by the Bank of England. Exchange rate is purely market determined Since 1999, the Euro has been in existence as twelve nations have established a single currency. Sterling floats freely against the Euro and also against the dollar, yen etc. The ERM experiment:  The ERM experiment Britain entered the ERM in October 1990 The main aims were to (i) Achieve exchange rate stability to promote trade (ii) Provide an anchor for Monetary policy in order to bring down inflation – the UK was fixing sterling against the low-inflation German economy Under the ERM UK interest rates had to be set at a level consistent with keeping sterling at agreed levels (DM 2.95) But the weakness of the British economy (recession, rising unemployment and a housing recession) meant that interest rates were probably too high for our own needs Inflation came down but sterling was weak The speculators attacked! Coming out of the ERM – Sept 1992:  Coming out of the ERM – Sept 1992 Counting the cost of leaving the ERM:  Counting the cost of leaving the ERM Treasury notes – published in February 2005(!) On Black Wednesday itself, September 16, 1992, the Bank of England sold some $28 billion of official foreign reserves trying to keep sterling within its ERM target range This intervention failed and sterling was forced out of the ERM and allowed to float freely Advantages: A lower pound boosted the competitiveness of exporters Interest rates could now come down in order to provide a boost to aggregate demand and take the British economy out of recession Fears of rising inflation proved unfounded – there was plenty of spare capacity in the British economy at the time Evaluating exchange rate systems:  Evaluating exchange rate systems Fixed versus floating rates King on exchange rate regimes:  King on exchange rate regimes Countries have always faced constraints in choosing their exchange rate regime. Any country can have only two out of the following three – an independent monetary policy, a fixed exchange rate and an open capital account. At various times countries have tried – and failed – to have all three As international financial markets have developed, there has been a general movement to flexible exchange rates supported by credible domestic monetary policies. That is a sensible use of the price mechanism to respond to complex and unpredictable shocks. The Case for Floating Rates:  The Case for Floating Rates Reduced need for holding currency reserves for use in intervention in the currency markets Useful instrument of macroeconomic adjustment e.g. a lower currency can stimulate aggregate demand Partial automatic correction for a trade deficit: Floating exchange rates offer a degree of adjustment when the balance of payments is in fundamental disequilibrium Reduced risk of currency speculation Freedom (autonomy) for domestic monetary policy – e.g. freedom to set interest rates to control inflation rather than the exchange rate Floating exchange rates are not always volatile exchange rates The Case for Fixed Exchange Rates:  The Case for Fixed Exchange Rates Stability is helpful for trade and capital investment Some flexibility of the currency is permitted (i.e. the occasional devaluation or revaluation of the currency) Reductions in the costs of currency hedging for businesses Fixed rate provides a discipline on domestic producers to keep their costs and prices down Reinforcing gains in comparative advantage: If one country has a fixed rate with another, then differences in relative costs will quite easily be reflected in changes in the rate of growth of exports and imports Dollar-Rouble:  Dollar-Rouble

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